Bollinger bands are a price channel comprised of three bands that contain price action.
The middle band represents the mean price of the last selected periods, usually 20. The upper and lower bands are almost always two standard deviations away from the mean.
In its simplest form, the middle band is a moving average that we use as the center of prices.
The upper an lower bands, however, represent the mean distance of the data set from the mean.
The structure described of the popular technical indicator allows forex traders to determine overbought and oversold levels, trends as well as breakouts. This is a must for understanding price action.
And it’s one of the first steps to becoming a better FX trader!
Why Master Bollinger Bands?
Since Bollinger bands represent the limits within which prices move, it’s a good tool to measure volatility in the forex markets.
In fact, it has been both mathematically and technically proven that the Bollinger bands are one of the best indicators one can use to measure volatility, containing nearly 90% of price action.
In short, 10% of the time markets offer an effective breakout (or every 9 hours on average if one trades the 1H timeframe!)
As you already figured, when prices deviate from the mean, the higher the volatility levels are in a given asset. That is to say, breakouts are often highly volatile. Note that it isn’t price action that determines volatility. It is the bid/ask prices.
At this level, you may be wondering: “what’s so special about volatility?”
Well, when trading forex, there is one critical component you need to get a very good handle on, which is the main reason Bollinger bands are so powerful. And that is the type of the market you trade or you are about to trade.
Everyone knows that any market can be flat, trending or breaking. What if I told you that volatility can help you identify whether you are looking at any of the above-market types? Here’s how…
Three Main Types of Markets
When the forex markets range, or trade sideways as widely known, there is no clear trend direction. In such a market type Bollinger Bands are flat as volatility is controlled within the upper and lower band limits at anywhere between 20 and 50 pips.
Ranging markets allow prices to easily penetrate the mean. Rarely, prices will range to the upper or lower part of the mean too. That is said to be a bullish or bearish biased market.
When the forex markets are trending, there is a clear trend direction no matter it is bullish or bearish. The FX markets can move continuously to the up or downside. And this is visually evident as the Bollinger Bands slope up or down, trying to catch up with prices.
When we are riding a trend, volatility is high but controlled. The middle band in such markets acts as a support or resistance trendline. And it becomes evidently harder to penetrate, providing relatively good signals to ‘follow the trend’.
When the FX markets are breaking, prices explode either up or down.
In most cases, the candle closes outside the upper or lower band. That, of course, depends on how many periods one uses. Volatility is at its peak level. Normally, breakouts are seen after a major news event or at the opening of a market session.
One characteristic of a breaking market is the fact that Bollinger bands become really tight before the ‘breakout’ occurs. Bands converge, diverge and then expand, chasing prices. The steeper the slope on the band, the higher the volatility levels in the particular asset.
Bollinger Bands & Price Action
Since contraction, mean reversion and expansion are part of Bollinger band forex trading let us now focus on some other interesting aspects of trading with Bollinger bands.
Apart from extremities, trends, and consolidations, Bollinger bands can also tell us when prices speed up or slow down.
That depends on the time taken to travel from one band to the other, or from one band to the middle band. For example, if it takes prices one hour to travel from the upper band to the medium band, versus, say, 2 hours, then we do know that during the first scenario, the markets were obviously faster.
Additionally, we can see some clues from the opposite band too. For example, when one Bolliger band slopes north but the other one, instead of expanding south, also turns north following the same directional, this is recognized as a slowdown. When the forex markets speed up, both bands must expand!
Setting Effective Bollinger Band Parameters
If you have in mind that Bollinger bands, or any other indicator for that matter, should have universal settings during an FX trading session, stop right there.
When one sets the periods of a forex indicator, volatility should always be under consideration. Why?
During any session, banks trade different sizes and quantities depending on the transactions they place for their clients, the capital that traders have available for speculative FX trading, and how their bonus is structured.
For that reason, considering a forex trading day usually starts with a low volatile session leading to a more volatile session, the following Bollinger band settings are suggested:
- European Open and up until London open: 20,2
- London Open and up until London close: 25,2
- London Close and up until New York close: 20,2
- Asian Open and up until European open: 14,1.9
In extreme situations, following steep moves, the Bollinger bands are better off at a 50, 2.1 parameter setting. In such a case, play the game by eyeballing it, but maintain the parameter figures as suggested above.