The Various Interpretations of Bollinger Bands
January 3, 2014 in Forex Articles
One of the primary advantages of using Bollinger Bands is that they can be interpreted in many different ways. This can be helpful for traders with stylistic methods or trading goals that vary from the wider major and makes Bollinger Bands a highly flexible tool that can be used by almost anyone. One of the most popular methods used by traders is to buy a currency once prices reach the lower Bollinger Band and then rise back through the middle Bollinger Band. Conversely, this strategy can also be used for sell positions, which would be initiated when prices rise to the upper Bollinger Band and then fall back below the middle Bollinger Band.
“The rationale behind most Bollinger Bands trading comes from the fact that prices have reached extreme levels, based on historical averages,” said Haris Constantinou, currency analyst at TeleTrade. “This tells us that a major high or low is in place.” Since we now have some sense of where prices are likely to be contained (inside the Bollinger Bands), we look for confirmation in the move. This can be seen once prices cross back through the middle Bollinger Band. In the bullish scenario, we can take buy positions once prices reach the lower band and cross back above the middle band. In the bearish scenario, we can take sell positions once prices reach the upper band and then cross back below the middle Bollinger Band. Trades are taken on the assumption that prices will next travel to the opposite Bollinger Band (which is where profits should be taken and trades should be closed.
Close Bollinger Bands Versus Wide Bollinger Bands
Another way that Bollinger Bands can be interpreted is to use the space between each Bollinger Band as a way of forecasting price activity. When the Bollinger Bands are seen tightening, this is an indication that market volatility is decreasing. Since markets are unlikely to stay this way for extended periods of time, this is also a suggestion that a breakout is imminent. Unfortunately, Bollinger Bands cannot tell us which direction will be seen (bullish or bearish). But once prices break through the tight Bollinger Bands, significant follow through can be expected.
Conversely, critical information can also be seen when Bollinger Bands are very wide apart. This occurrence indicates that market volatility is heightened and since prices have difficulty maintaining these extreme levels for very long, wide Bollinger Bands suggest that markets will need to calm down and revert back to normal averages so that the “dust can settle” and the previous volatility can ease. So, when Bollinger Bands are seen as being very wide, it is generally not a good idea to place a trade in the direction of the over-riding trend. Instead, contrarian positions should be considered because the wide Bollinger Bands are giving an indication that the previous trend is ready to end.