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How to Use Bollinger Bands in Forex Trading
12/10/2010 12:01 am EST
Bollinger bands are among the most popular technical indicators for traders in any financial market, be it stocks, bonds, or foreign exchange (FX). Many traders use them primarily to determine overbought and oversold levels, selling when price touches the upper Bollinger band and buying when it hits the lower Bollinger band. In range-bound markets, this technique works well, as prices travel between the two bands like balls bouncing off the walls of a racquetball court.
Yet as John Bollinger was first to acknowledge, "Tags of the bands are just that; tags, not signals. A tag of the upper Bollinger band is not in and of itself a sell signal. A tag of the lower Bollinger band is not in and of itself a buy signal." Price often can and does "walk the band." In those markets, traders who continuously try to "sell the top" or "buy the bottom" are faced with an excruciating series of stop-outs, or worse, an ever-mounting floating loss as price moves further and further away from the original entry.
Perhaps a more useful way to trade with Bollinger bands is to use them to gauge trends. To understand why Bollinger bands may be a good tool for this task we first need to ask, "What is a trend?"
Trend as Deviance
One standard cliche in trading is that prices range 80% of the time. Like many cliches, this one contains a good amount of truth since markets mostly consolidate as bulls and bears battle for supremacy. Market trends are rare, which is why trading them is not nearly as easy as it seems. Looking at price this way, we can then define trend as deviation from the norm (range).
The Bollinger band formula consists of the following:
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
n = Smoothing Period
m = Number of Standard Deviations (SD)
SD = Standard Deviation over Last n Periods
Typical Price (TP) = (HI + LO + CL) / 3
BOLU = MA(TP, n) + m x SD[TP, n]
BOLD = MA(TP, n) - m x SD[TP, n]
At the core, Bollinger bands measure deviation. This is the reason why they can be very helpful in diagnosing trend. By generating two sets of Bollinger bands, one set using the parameter of "one standard deviation" and the other using the typical setting of "two standard deviations," we can look at price in a whole new way.
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In the chart below, we see that whenever price channels between the upper Bollinger bands +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the "buy zone." Conversely, if price channels within Bollinger bands -1 SD and -2 SD, it is in the "sell zone." Finally, if price meanders between +1 SD band and -1 SD band, it is essentially in a neutral state, and we can say that it's in "no man's land."
One of the other great advantages of Bollinger bands is that they adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.
A Tool for Trend Traders and Faders
Having established the basic rules for Bollinger bands, we can now demonstrate how these technical tools can be used by both trend traders who seek to exploit momentum, and fade traders who like to profit from trend exhaustion. Returning back to the AUD/USD chart just above, we can see how trend traders would position long once price entered the "buy zone." They would then be able to stay in trend as the Bollinger bands encapsulate most of the price action of the massive up move.
What would be a logical stop-out point? The answer is different for each individual trader, but one reasonable possibility would be to close the long trade if the candle turned red and more than 75% of its body was below the "buy zone." Using the 75% rule is obvious since at that point, price clearly falls out of trend, but why insist that the candle be red? The reason for the second condition is to prevent the trend trader from being "wiggled out" of a trend by a quick probative move to the downside that snaps back to the "buy zone" at the end of the trading period. Note how in the following chart, the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.
Bollinger bands can also be a valuable tool for traders who like to exploit trend exhaustion by picking the turn in price. Note, however, that countertrend trading requires far larger margins for error, as trends will often make several attempts at continuation before capitulating.
In the chart below, we see that a fade trader using Bollinger bands will be able to diagnose quickly the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger bands by shorting the next tag of the upper Bollinger band. But where to place the stop? Putting it just above the swing high will practically assure the trader of a stop-out, as price will often make many probative forays to the top of the range, with buyers trying to extend the trend.
Here is where the volatility property of Bollinger bands becomes an enormous benefit to the trader. By measuring the width of the "no man's land" area, which is simply the range of +1 to -1 SD from the mean, the trader can create a quick and very effective projection zone which will prevent him or her from being stopped out on market noise, yet protect his or her capital if the trend truly regains its momentum.
As one the most popular technical indicators, Bollinger bands have become crucial to many technically oriented traders. By extending their functionality through the use of Bollinger bands, traders can achieve a greater level of analytical sophistication using this simple and elegant tool for both trending and fading strategies.By Boris Schlossberg of BKForexAdvisors.com
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