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Bollinger Bands appear as an overlay on a chart and are plotted a number of standard deviations above and below a moving average. The standard setting is 2 standard deviations either side of a 20-day simple moving average (SMA). This is the default setting on the Spread Co platform although these parameters can be changed easily.
1. To track market volatility
2. To track price movements
3. As a market indicator (not in isolation)
Now lets take a look at these in more detail below:
Standard deviation is a measure of volatility, so Bollinger Bands adjust themselves to market conditions. When market volatility increases, the bands widen, moving further away from the SMA. During less volatile periods, the bands contract and move closer to the SMA. The tightening of the bands is often used by technical traders as an early indication that volatility is about to increase. Traders then look to trade in the same direction of the developing trend if the bands subsequently diverge (widen) sharply.
Another common way of utilising Bollinger Bands is to track price movements in relation to them. It is unusual for prices to break above the upper band or below the lower one. In fact, it’s calculated that prices will fluctuate between the upper and lower bands around 90% of the time. So a breakout is often an indication that something is going on. The big question though is how to trade it. For some traders the closer that prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. This would suggest selling the market when prices break above the upper Bollinger Band and buying when prices break below the lower Bollinger Band. However, this won’t work if the market is trending, as we can see below. This chart shows the sell-off in the EURUSD from the summer of 2014 to March 2015. As we can see, prices tracked the lower Bollinger Band very closely.
Consequently, one should never trade off Bollinger Bands (or any technical indicator) in isolation. Instead, look for confirmation from another indicator. Or, use Bollinger Bands to confirm a signal from another indicator. The chart below again shows a section of a chart for the EURUSD. There’s a Bollinger overlay with a MACD (Moving Average Convergence/Divergence) below. Looking at the left hand side of the chart first, together with the MACD, we can see the blue MACD line cross above the red signal line. This coincides with prices hugging along the bottom Bollinger Band just before they break higher. Admittedly, the EURUSD then trades sideways for a while. But we can then see the Bollinger Bands narrow slightly indicating a fall in volatility before prices shoot higher for a second time. The signal to sell comes as prices break above the upper Bollinger Band and then the blue MACD breaks back below the red signal line.
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