What are Bollinger Bands?

Bollinger bands are lines that indicatethe volatility of a currency pair. They were created by John Bollinger. The top line can be used as a sell signal or the bottom as a buy signal. The width between the bands can also be used to identify conditions where a pair is likely to breakout of a range in which it has previously been trading.

Bollinger bands explained

In a Bollinger bands indicator, there are three bands. The middle band is a 20 period moving average. Two standard deviations below the middle band is the bottom band. Two standard deviations above the middle band is the top band. When the space between the Bollinger bands expands, it means the currency pair has higher volatility. When the space between the Bollinger bands contracts, it indicates the pair has lower volatility.

Bollinger bands example

In this chart of AUD/USD, we can see several periods where the Bollinger bands either expanded or contracted. During the expansion periods, the pair was trending. During the contraction periods, it was consolidating.

Points to remember about Bollinger bands

There are several points to remember about Bollinger bands. Here are a few:
  1. In a ranging market, the price tends to move toward the middle band.
  2. When the price hits the top band, it usually falls.
  3. When the price hits the bottom band, it usually rises.
  4. When the bands contract, it means the price is stuck in a tight range. This often results in a breakout.
  5. If the price goes above the top band during a period of excessive contraction, it indicates a possible upside breakout. This is an exception to #2.
  6. If the price goes below the bottom band during a period of excessive contraction, it indicates a possible break downward. This is an exception to #3.
 

How to trade using Bollinger bands

There are several strategies where Bollinger bands can be used. One is to go short anytime the price hits the top band and long if it hits the bottom band. In this case, a trader can use the middle band as a take-profit point. A stop-loss can be placed just above the top band or just below the bottom band to limit losses in case the pair breaks out. Another strategy is to wait for the bands to contract, then to buy when the price hits the top band or sell when it hits the bottom band. This is sometimes called the “contrarian Bollinger bands” strategy. In this case, a stop can be placed slightly above or slightly below the middle band. Bollinger bands are a measure of the volatility of a currency pair. In a ranging market, Bollinger bands indicate to traders where the price is likely to reverse and move back to the middle of the range. They can also be used to catch breakouts. As a result, Bollinger bands are useful for finding entry and exit points in trades.