4.33 Trading with Bollinger Bands®
The set of Bollinger Bands is another intriguingly named indicator which you can add to your arsenal.
Remember Arnold Schwarzenegger and all the weapons he carries in the movie ‘Commando’ as he storms out of the beach to take on the bad guys?
Well, you need all that and more when you step up to claim your share of pips from the Forex market!
Bollinger bands are not a musical group, sorry to disappoint you, but a set of lines invented by a guy called John Bollinger. These lines put you on alert whenever the market starts doing something out of the ordinary, or putting it another way, becomes more volatile.
Look at the Forex chart above. It shows a price plot with a moving average line running through the middle of it. There are two more lines, one above and one below the middle line – these are the ‘bands’. Can you see how the price is behaving? It alternates between the higher and lower bands but tends to return to the middle (the mean) most of the times.
This is typical price behavior when the market is not in a clear trend, and is just sort of ‘middling’ along. Also, see how the bands on either side are also cruising by without running off in some one direction. It’s a boring time for Forex traders with limited scope for plucking pips. Let's see how.
Trading Ranging markets or weak trends with Bollinger Bands
During ranging markets and also during weak trending ones, the upper and lower bands tend to act as dynamic resistance and support, respectively, you can keep yourself occupied in such a range-bound market by trading ‘buys’ around the lower band and ‘sells’ around the upper band.
In such long and short positions, you may like to target the middle band for profit taking for half of your position size and the opposite band as second target for remaining half of your trade position.
Bollinger Band to Identify Beginning of a Trend
You remember that "Silence Before a Storm" thing? Well, you will find your bands to act to make that saying true most of the time. When the bands shrink down or squeeze, you may expect a strong break out from the range and a storm to hit the market. Well, the storm here stands for a trend.
What to look for:
- Bollinger bands suddenly narrowing down or squeezing.
- Check which band, lower or upper, is failing to act as support or resistance. More than this, please check whether the middle band tends to act as support or resistance.
- If the middle band starts acting as support then expect an uptrend to begin but in case it starts acting as resistance then a downtrend should be around the corner.
Now let’s see a chart of what happens when the market starts to really trend up or down.
Our friends, the bands, usually go into a huddle before this happens. So, be on your guard when you see the bands start to ‘squeeze’ together, like this.
What does this mean? It means that the market volatility has reduced, and that the price is about to break out in either direction. Arnie would reach for the rocket-launcher(s) and be ready to fire! You now keep you fingers poised on the Enter key to put in a trade.
In the above Forex chart, a breakout is looking to form. Please note that as the price tried to pierce through the lower band, the chances of a market having made up its mind by bears pulling down the volatility with their short-selling orders is more. However, we need to wait to see whether the middle band starts acting as support or resistance. Let's see what happened next:
The downward break did not sustain and then the middle band turned into support. Result? Well, the bulls took the command and an uptrend begun.
Or this, a downtrend:
This is a fairly reliable strategy to collect some pips – go short on the downside breakout and long on the upside breakout.
Calculation and construction
As a trader, you don't really need to know about all the calculations which go behind constructing Bollinger bands. You just select the tool on your trading chart and start trading. But if you really want to know then here we go:
The middle band is nothing but a simple moving average of the closing prices. The upper and lower bands are based on the calculation of standard deviation.
Let's assume that we are working on Bollinger bands based on 14 periods then the calculation will be as follows:
Calculation for standard deviation
- Calculate the simple moving average for 14 periods.
- Deviation for a period = closing price for that period - simple moving average for 14 periods. The deviation is positive if the closing price is more than the moving average and negative if the closing price is less than the moving average.
- Square the deviation of each period. By squaring any negative values will become positive.
- Add all the squared deviations for the 14 periods. Say the sum = D.
- Divide the sum of the squared deviation by the number of periods i.e. D/14. Basically what we have done is calculated the average of the squared deviations for all the periods. Let's say (D/14) = N.
- Calculate the square root of the above i.e. square root of (D/14). This is the standard deviation for the 14 periods.
If you analyze this calculation you would observe that the initial squaring was done just to get rid of the negative values, as at the end we had again taken square roots of all those values. The standard deviation is always a positive value.
So let's see what the Bollinger bands represent. Check the following:
- Middle Band = Simple moving average for 14 periods.
- Upper Band = Middle band + (2 x standard deviations for 14 periods).
- Lower Band = Middle band – (2 x standard deviations for 14 periods).
Period Settings for Bollinger Bands
The quite preferred setting for the Bollinger Bands is "14,2". Here 14 represents the number of periods for which the moving average is calculated and 2 represents the multiplication factor for the standard deviation.
- How to Use Bollinger Bands