Bollinger Bands are one of the tools in technical analysis which identify volatility of a currency pair. It determines overbought and oversold levels, to monitor breakouts, and as a trend-following tool.
You can directly apply it to the price chart, analyze the market, and look for trading signals.
The upper band is a high or expensive level. Therefore, when the price nears this level, it suggests that the security is expensive. When it reaches the upper band, it indicates overbought, triggering a sell signal.
The lower band is a low or cheap level. Therefore, when the price nears this level, it suggests that the security is cheap. When it comes in contact with the lower band, it indicates oversold, triggering a buy signal.
What is the Bollinger Bands Indicator?
The Bollinger Bands Indicator is a type of moving average indicator, but with two additional bands that record price deviation from a security’s true value.
It uses standard deviation, which is used to evaluate the volatility of the price. Unlike other indicators which use support and resistance levels, Bollinger bands expand or contract depending on the price behavior.
How to use Bollinger Bands
The Bollinger Bands Indicator has three lines:
- one exponential moving average (center line)
- two price channels above and below (upper and lower band)
The line in the center makes use of 20-day simple moving average (SMA) of the prices. The upper and lower bands track the standard deviations of the price.
The volatility of the market is reflected on the gap of the upper and lower bands from the middle one. When the market is more volatile, it expands; when less volatile, it contracts.
How to calculate Bollinger Bands
Every line has a specific function, therefore, each line must be computed to get the overall result.
The Bollinger Bands calculator
Note: To calculate the middle line or the 20-day SMA, add the daily closing prices of the last 20 days and divide it by 20.
What Bollinger Bands tell us
The Bollinger bandwidth represents the volatility of the market. It widens when the market is more volatile and contracts when less volatile.
A squeeze is when the two bands contract towards the middle. It indicates that there is about to be a breakout.
A bounce is when the middle line reaches the upper band and then bounces back. It is indicative of a retracement.
Limitations of Bollinger bands
The Bollinger Bands may not be fully accurate in interpreting the psychology of the market as it only follows the behavior of the price, and not forecast its movement.
Due to its limitations, it can be better utilized when combined with other indicators such as the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD).
Which indicators are better to use with Bollinger bands
Using Bollinger Bands with RSI: when the price reaches the upper band and the RSI reads a 70, it indicates that the security is overbought, triggering a sell signal.
Conversely, when the price reaches the lower band and the RSI reads 30, it indicates that the security is oversold, triggering a buy signal.
Using Bollinger Bands with MACD: you can determine whether the new highs or lows in the price of a currency pair will remain in momentum, or simply wane in a matter of time.
Bollinger Bands are useful in evaluating trends as it reacts to the price movement. It takes in historical data of the price movement of a currency pair and forms market analysis through it. However, as it is reactive, it can be a good idea to utilize Bollinger Bands with indicators that are predictive of price changes to attain a strong strategy for your overall trading plan.