Bollinger bands have become a popular technical analysis tool for Forex traders. One of the reasons this tool is so useful is because if its ability to adapt to changing market volatility.

So what exactly are Bollinger bands? I have to give credit to my good friend Tony Hosea for what he calls a “simplified” explanation. The “bands” themselves are lines which run above and below a simple moving average of the prices. Initially bands were created by adding and subtracting a small percentage of the moving average. An upper band could be created by multiplying the moving average by say, 1.03 for 3%. For the lower band 3% is subtracted from the moving average.

In our fixed percent example above, the bands stay at a relatively fixed distance from the moving average. Mr. John Bollinger changed the way traders looked at using price bands by creating his bands using standard deviation rather than fixed percentages. The typical settings of Bollinger Bands (BB) use a setting of 20 periods (weeks, days, hours, etc.) and 2 standard deviations. The top band is formed by adding 2 standard deviations to the moving average and the bottom band is formed by subtracting 2 standard deviations from the moving average.

BB’s gave traders a new way of visualizing the markets because the bands themselves dynamically expand when market volatility increases and contract when market volatility decreases. The BB’s themselves can be used as a volatility filter and also to indicate important price high’s and low’s.

Some technical analysts may prefer to trade directly from the bands themselves. If a trader is short the EURUSD and the price touches the lower band, they may choose to close their short position or to take profits on some of the contracts they hold. Conversely if you are long EURUSD and the price touches the upper band you may wish to either exit your long position or take profits on some of the contracts you hold. Both of the methods just described are exit strategies. BB’s may also be used to enter trades as well. If you are looking for an entry point for the EURUSD you may choose to wait until it touches the upper band to initiate a short position as the touching of the upper band may indicate a slowing of upside momentum and the possibility of a price reversal. On the flip side of the coin you could also wait until the price touches the lower band to initiate a long position.

One additional effective method of using BB’s to trade is to wait for a currency pair’s price to close below the lower band. Next you will want to establish a long position once the price closes above the lower band. This is decidedly different than going short once prices fall below the lower band. This method provides more of a level of confirmation since the price has actually reversed to close above the lower band.

As you can see Bollinger Bands can be used to trade more effectively. Because they move with the dynamics of the market they are useful tools to have in your technical analysis toolbox.

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