Bollinger Bands Explained

Definition of Bollinger Bands

Created by John Bollinger, the Bollinger Bands are trend indicators that give an indication as to the trading range of a currency pair, as well as provide a measure of market volatility and expect the trading range.

The Bollinger band indicator is made up of three bands. The market volatility is what determines the range of pips between the upper band and the lower band. When there is high market volatility, the range is wider. When the market is quiet, the bands narrow significantly to form the “Bollinger Squeeze”.

Bollinger Bands can also serve to determine the extremes of price action. In a range-bound market where the Bollinger bands are nearly horizontal, the upper and lower bands can be used to determine overbought and oversold conditions.

Components of the Bollinger Band Indicator

The Bollinger band indicator is made up of the following components:

  • The middle band, which is a 20-period moving average
  • Upper band, which is set at 2 standard deviations from the middle band to the upside. Also defined as middle band + (2 * 20 period standard deviation).
  • Lower band, which is also set at 2 standard deviations from the middle band to the downside. Also defined as middle band – (2 * 20 period standard deviation).

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Indicator Settings

The indicator is listed on the MT4 among the Trend indicators. To attach it to the MT4 chart, click on Insert > Indicators -> Trend -> Bollinger bands.

In terms of appearance, some modifications to the indicator can be made. These modifications can be either to increase or reduce the line thickness of the individual moving averages or to change their colour to make them distinct from each other, especially when several moving averages are used.

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The upper and lower bands can also be made wider or narrower by adjusting the standard deviation of both bands from the middle band. We showed how this is done in our article on the Extended Bollinger Band strategy.

Usage of the Bollinger Bands in Forex Trading

The Bollinger band indicator is used in several ways when it comes to forex trading.

  • It is used to detect areas where the currency pair is overbought or oversold in range-bound markets. Here, it must be used alongside an oscillator such as the Stochastics oscillator to confirm this situation.
  • It is used to trade breakouts when the initial appearance is that of the Bollinger squeeze.

1) As an Overbought/Oversold Indicator

This strategy only works if the market is range-bound. Here, the trader looks to short the currency pair at the upper band, and to buy the currency pair when price is at the lower band. Confirmation from an oscillator is used. This is the basis of the Basic Bollinger strategy discussed here. The emphasis here is on the market being range-bound (Bollinger bands will be sideways). Note that the Bollinger bands are based on volatility and do not stay in one area for long.

This strategy is also used when the standard deviation of the Bollinger bands is increased so that it can encompass all price activity in the market. We also discussed that strategy here.

2) Breakout Trading

This strategy deploys the Bollinger squeeze, which is formed when volatility is so low that the bands contract into a very narrow range.

Trade Example

We discussed the Bollinger squeeze strategy which teaches traders how to trade the breakout of the price action from the Bollinger squeeze situation. To refresh your memory, the Bollinger squeeze breakout is performed using the Bollinger bands in combination with the Keltner channels indicator. We look for where the Bollinger bands enter into the Keltner channels (the squeeze) and trade the direction in which the price breaks out from the Bollinger band when it re-emerges from the Keltner channels.

While we will not go into full details of the Keltner channel_Bollinger band strategy here, you can look up the strategy here on Investoo.com, as well as download the Keltner indicators hereBollinger_Keltner

This is a typical trade situation in the Bollinger squeeze. The trade is taken in the direction of the breakout. Here, this would be the long trade as the price broke the upper Bollinger band when the band re-emerged from the Keltner channels.

Conclusion

It is essential that you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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