Sending my regards to everyone. Financial markets attract
attention from investors and traders all around the world. In these dynamic
environments, asset prices change rapidly, and new opportunities arise at any
moment. However, deciphering the meaning of this volatility in the markets and
predicting future price movements is one of the most complex and exciting
problems in the financial world. To successfully trade in the Forex market, we
strive to understand the reasons behind each fluctuation. This is where
technical indicators come into play. We use technical indicators to analyze the
price movements of financial assets and support our trading decisions. These
indicators are designed to forecast future price movements based on past price
data. With the help of these indicators, we aim to determine the overall
direction of the market, identify trends, and receive buy/sell signals. There
are many different technical indicators, each representing a specific purpose
or approach to understanding market behavior. These indicators are used for
various purposes, such as identifying trends, defining overbought or oversold
zones, and measuring momentum. In this article, we will discuss a popular
technical indicator called “Bollinger Bands” and how it works.
What are Bollinger Bands?
Bollinger Bands are a widely favored and extensively used indicator by almost anyone trading in financial markets. Developed by John Bollinger, this indicator is a volatility band placed above and below moving averages. It is used to determine the volatility of financial asset prices and possible trend changes. Bollinger Bands are known as a dynamic indicator based on volatility, which measures how much prices fluctuate over a certain period. Calculated using a statistical measure like standard deviation, this indicator causes the bands to expand or contract based on increases or decreases in volatility. When market volatility increases, the bands expand, and they contract when volatility decreases. This feature gives us a quick overview of how volatile the market is.
Components and Calculation of Bollinger Bands
Bollinger Bands are the most widely used technical research
in technical analysis. This indicator consists of three basic components. These
are the following:
1.Middle Band (SMA - Simple Moving Average). The
middle band is a core component of Bollinger Bands. It’s usually calculated as
a 20-period Simple Moving Average (SMA). A moving average is a value obtained
by dividing the sum of prices over a specific time period by the number of
periods used. For example, a 20-period moving average shows the average of
prices over the last 20 time periods. The middle band often represents a
central reference point for price movement and indicates the average level of
prices. It’s used to identify trends and understand the general direction of
prices. When prices are above the middle band, it’s commonly considered an
uptrend, and when below, a downtrend. The middle band is also used to calculate
the upper and lower bands. These bands are placed above and below the middle
band and expand or contract based on volatility.
2. Upper Band. The upper band, which is the second main
component of Bollinger Bands, is a band located above the middle band. It’s
typically calculated by adding a certain standard deviation value to the
20-period moving average:
Upper Band = 20-day Simple Moving Average + (20-day Price
Standard Deviation x 2)
This standard deviation value measures how far prices
deviate from the average. The upper band sets the upper limit of this moving average and indicates how high prices can go. Price movements that cross the
upper band are interpreted as an overbought condition. In other words, when
prices in a sideways market reach a level above the upper band, the price is
seen as being in the overbought zone, suggesting a correction or pullback may
be expected.
3. Lower Band. The lower band, the third component of
Bollinger Bands, is a band located below the middle band. Similar to the upper
band, the lower band is typically calculated by subtracting a certain standard deviation value from the 20-day moving average:
Lower Band = 20-day Simple Moving Average - (20-day Price
Standard Deviation x 2)
In this case, the standard deviation indicates how far
prices deviate below the average. The lower band establishes the lower limit of
this moving average and suggests how low prices can potentially drop. Price
movements that go below the lower band are considered an oversold condition. In
other words, when prices reach a level below the lower band, the market might
be in an oversold zone, suggesting a possible upward correction or recovery.
The upper and lower bands are a reflection of Bollinger
Bands’ volatility-based dynamic structure. These bands are used to indicate how
much prices have moved within a specific range and to highlight possible trend
changes.
How to Trade with Bollinger Bands?
Bollinger Bands perform exceptionally well in sideways
markets. In this context,, the Lower Band, Upper Band, and Middle Band play
roles as support and resistance. If the price breaks above the Middle Band from
below, the Upper Band acts as resistance, and the Middle Band serves as
support. During this time, we place a Buy order once prices break the
Middle Band. Conversely, if the price crosses the Middle Band from above, it’s
likely to move down towards the Lower Band. In this situation, we place a Sell
order. In both cases, we expect prices to bounce off the Lower or Upper Bands,
and we open corresponding Buy or Sell positions. Essentially, this approach is
effective in sideways markets.
 |
| Using Bollinger Bands in the AUD/NZD chart |
In times of market instability, consolidation occurs, and Bollinger Bands begin to narrow. When the bands narrow, it typically signifies low volatility, indicating an approaching price movement. This is often observed before a reversal or a significant move. As the market breaks out of consolidation, it either initiates a strong upward trend or a strong downward trend. This is when Bollinger Bands expand. Expanding bands usually mean increased volatility, indicating a period of heightened price fluctuations. During this time, the role of the Lower or Upper Band as support and resistance becomes less effective. When Bollinger Bands expand and the sideways market ends, we place a Buy order if prices move with the Upper Band. In this case, we consider the Middle Band as a support line. If prices move with the Lower Band, we place a Sell order, considering the Middle Band as a resistance line. Take a look at the presented example in the AUD/NZD chart above.
Constantly remind yourself that, While the Forex market is known for its complexity, high volatility, and liquidity, it also carries risks. Therefore, no single technical analysis indicator provides meaningful results on its own. Bollinger Bands alone don’t create a complete trading strategy. Prices generally move within the bands, but occasionally they can go beyond, leading to false signals. The most accurate approach involves using Bollinger Bands in combination with other indicators, particularly volume indicators. Successful trading!