Bollinger Bands identify the degree of real-time volatility for a currency pair
Volatility describes the degree by which an exchange rate varies over time. Traders pay close attention to volatility since it tends to increase just prior to a rate reversal. As the reversal gains in momentum, volatility tends to sharply increase as traders act to take advantage of the change in direction.
Developed by technical analyst John Bollinger in the 1980s, he took the idea of plotting moving averages one step further by using the concepts of standard deviations to define upper and lower rate boundaries. These boundaries form the pricing channels used to measure volatility.
Standard deviations are a statistical unit of measure describing the dispersal pattern of a data set. When working with Bollinger Bands, it is not necessary for you to calculate standard deviations yourself. You need only understand the theory of how standard deviation sets the range for a dispersal of rates when compared to the moving average, and how this information is used to determine buy and sell channels in the chart. By definition, one standard deviation includes about 68% of all data points from the average in what is referred to as a normal distribution pattern, while two standard deviations include about 95% of all data points.
BUY AND SELL CHANNELS
Bollinger Bands are placed over a price chart and consist of a moving average together with upper and lower bands. The area between the moving average line and each band produces a range, or channel. Bollinger Bands show relative volatility changes through the width of the bands themselves — the wider the bands, the greater the volatility.
The area above the moving average is referred to as the buy channel as spot rates displayed in this region remain higher than the moving average and suggest upward momentum.
Conversely, spot rates falling below the moving average are in the sell channel as the spot rate is declining more rapidly than the moving average which suggests that the exchange rate has downward momentum.
In this example, you can see that at the far left of the chart, the upper and lower bands are close together and are near the moving average line. However, they start to widen and the rate also begins to climb until it reaches a peak and then falls. The exchange rate then flattens out and the upper and lower bands begin to move closer together indicating that volatility has subsided.
BREAKING THE BANDS — TREND REVERSAL SIGNALS
When the spot rate falls outside the bands, it is said to be "breaking the bands". Breaking the bands occurs during times of extreme volatility and is the strongest signal issued by Bollinger Bands that a trend reversal is imminent. Because two standard deviations include about 95 percent of all data for a normal data pattern, market rates should only break the bands about 5 percent of the time with this formula.
Traders use the terms over-bought to describe the situation where spot rates break the buy band, and over-sold when spot rates break the sell band. Both are acknowledged as market reversal signals.
In this example, you can see that the currency pair was trending downwards until the point where three consecutive closes break the sell band barrier just after the 10:20 time period. This is a strong reversal signal that identifies a possible "buy-in" point.
DOUBLE TOPS AND DOUBLE BOTTOMS
The existence of price chart patterns such as double tops and double bottoms can help identify buy and sell opportunities.
When a rate reaches the highest level that the market is willing to pay - that is, the resistance level - the rate usually holds at the level creating a second plateau more, or less equal to the previous level. This is the second part of the double top and if the rally is to be extended, the second top may be slightly higher. If the subsequent top is lower, this is seen as a signal that a rate reversal is imminent as traders sell their positions, or short the currency pair outright in anticipation of a drop in the exchange rate.
A double bottom is basically the same as a double top, but is seen as a signal that the support level for an exchange rate has been reached resulting in an increase in the rate. This is because once the market is prepared to support the rate from dropping further, buyers enter the market in an attempt to buy into the currency pair at a low point prior to an upswing.
In this example, after several closes below the support level, the exchange rate reversed its direction shortly after posting a double-bottom. A double-top signified the end of a series of intra-period closings above the top band (the resistance level) indicating a rate reversal.
John Bollinger believed "20,2" to be the optimal setting for most situations. In this example, the settings in the top left corner are circled. These numbers indicate the time periods used to calculate the moving average "20" and the standard deviations away from the moving average to position the upper and lower bands "2".
With the OANDA platform, you have the ability to experiment with these settings, but please keep these two points in mind if you do experiment:
1. Keep most of the exchange rate fluctuations within the bands. If spot rates break through the bands too frequently, it will become impossible for you to distinguish between a typical fluctuation and a possible reversal signal.
2. If market rates rarely break the bands, consider reducing the number of reporting periods for which the average rate is calculated.
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