How to use Bollinger Bands in your Forex Strategy?
Bollinger Bands, a technical analysis tool created by John Bollinger, is widely used by professional traders and helps them to identify trends, breakouts, and overbought and oversold levels. It consists of three lines—the midline and two outer bands enveloping the candles. The midline line represents a 20-day simple moving average, whereas the outer two lines represent standard deviations and are 2 standard deviations apart from the mean or simple moving average.
How to interpret the Bollinger Bands?
The price action candlesticks move inside the bands, with the top band representing a resistance level and the lower band representing a support level. When the candlesticks touch the top band, the forex pair is considered overbought, signaling the start of a downward movement in price. Conversely, when the price crosses the midline — the 20-day simple moving average — it is a signal of weakness in the trend. When the price hits the lower band, it indicates that the security or the currency pair has reached the oversold level, signaling a reversal in the downtrend.
While analyzing the image placed above, you can notice that the bands contract and expand on the timeline. The expanding bands reflect higher volatility, after which you can expect a lower volatility. Hence, the bands expand and contract one after the other.
A breakout outside the lower and upper bands does not sustain longer and reverses quickly, presenting a good trading opportunity.
How to trade using the Bollinger Bands?
As mentioned above, the bands act as crucial support and resistance levels, which you can also interpret as overbought and oversold levels. By identifying these levels, you can take your trading position accordingly. If the price action hugs the top band and moves upward piercing it, the trend will be strong and vice versa. You should, however, keep an eye on the volatility as well. The higher volatility will expand the bands, whereas lower volatility will contract the bands. Therefore, when entering a trade during higher volatility, you are taking a higher risk with higher profit potential.
You can tinker with the settings of the Bollinger Bands and customize it as per your liking. For example, instead of keeping the standard deviation at 2, you can change it to 1, or you can add another set of bands each with 1 standard deviation apart from the mean.
When you add another set of Bollinger Bands with 1 standard deviation to the price action, it will allow you to detect trends quickly. If there is an upward or downward trend, the price action will move between the 1 and 2 SD bands. As soon as the candlesticks move outside the 1 and 2 SD bands, it is a sign of weakening of the trend and you can get out of the trade.
Bollinger Bands is a very useful tool, and every trader should thoroughly understand it and test it on historical data before using it in the real market. It will give you valuable information regarding price action, volatility, trend and breakouts, allowing you to make informed trades.