Trading with Bollinger bands

Bollinger bands are a favourite trading indicator used by many professional traders to spot profitable opportunities in the forex markets. Developed by John Bollinger during the 1980’s, Bollinger bands are drawn two standard deviation away from a simple moving average. The result is a set of 3 lines which move narrower and wider as price becomes more and less volatile. When price becomes volatile, the bands will widen and when markets are stable the outer bands will contract nearer to the moving average.

How are Bollinger bands used in forex?

Typically traders use Bollinger bands to determine when a market may be overbought or oversold, as well as predicting breakout movements in the near future. Overbought signals areas are when price moves to the upper band and beyond this, an indication that at some point price will need to return to the central moving average. Oversold signals are given when the opposite occurs and price moves down and beyond the lower Bollinger band.

In sideways or inactive markets traders view the narrowing of the Bollinger bands as a signal that the market is ready to break higher or lower, often substantially and providing a large move for traders able to get in to the trade early. Looking at historical charts, this setup is clearly shown on all timeframes with all three Bollinger bands almost touching before price moves higher or lower.

Bollinger bands and the continuation trade

Another way of trading with Bollinger bands which does not follow the conventional wisdom is to use these to spot opportunities for a momentum trade. This setup relies on the logic that once price moves towards either of the outer Bollinger bands it is likely to have enough momentum to move further in this direction in the short term. The specific signal to trade this setup is for price to touch the outer Bollinger band without being in contact with the central moving average. Once the bar touching the outer Bollinger band has closed, opening a trade on the following bar will often result in a profitable trade higher or lower with the central moving average becoming the stop loss level. This setup can be seen to work most effectively on the 5 minute and hourly forex charts.

Using volume and Bollinger bands to signal reversals

An additional way to trade Bollinger bands is to combine these with a volume indicator. The setup using these two indicators occurs when price closes outside of one of the outer Bollinger bands and volume for the same price bar decreases. This suggests that the movement is not heavily supported and there is a high likelihood that price will reverse back within the Bollinger band. Conversely, for those price bars that close outside of the Bollinger bands on unnaturally high volume, this can also represent an exhaustion bar and it is very likely that the following bar will move in the opposing direction.