Currency Trading Analysis: Using Bollinger Bands, A Vital Device For Technical Forex Traders
Bollinger bands on currency trading charts are used just as on equities and options trading charts, as an indicator to make the trader aware of a new forming movement, breakout or trend. They are made up of three lines or bands.
The central band is a simple moving average over a certain number of periods, normally 20. The upper and lower lines are at a fixed number (usually 2) of standard deviations calculated with reference to the number of intervals used for the center band.
Bollinger bands were discovered by John Bollinger in the 1980s. The assumption behind them is that prices will generally remain within 2 standard deviations of the average, which here is the moving average used to plot the middle line. This implies that as prices reach the upper and lower band lines, a reversal is signaled to keep the prices within the bands.
They are also an indicator of fluctuation. Wider bands point to a more volatile market than narrow bands.
Traders use Bollinger bands in a number of different ways but these are the two most popular ones:
1. Identification of overbought and oversold market conditions
On the basis that prices are seeming to stay within the bands, some traders will use Bollinger bands as an indicator to sell when the price rises above the upper line and buy when it dips below the lower line. Typically they will plan to close their trade when the price approaches to the central line.
Caveat is important here, however, as these movements outside of the bands may just signal a strong trend forming in that direction. So you could be caught on the wrong side of a powerful price movements in some cases. John Bollinger himself recommended frequently examining against different indicator. Most likely the most suitable for this purpose are non-oscillating indicators such as trend lines or chart patterns.
2. Identification of contraction and foretelling breakout
As we have seen, the bands will diverge and converge consistent with the volatility of the market over the measured past intervals. When they converge so that their area becomes narrow, this is called contraction. Some traders will act assuming that contracting bands is an indicator of a powerful breakout and place both buy and sell orders outside the bands.
The danger here is that there can often be a misleading move where the prices will stretch outside the bands briefly prior to turning. For this reason some traders prefer not to act on the first move outside the bands. Again you should always check against another indicator on your currency trading charts, or use forex signals as a checking tool. A forex signal is a market forecast and a trading recommendation, which can be used as a confirmation, especially if comes from a reliable forex signal provider.
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