Developed by John Bollinger, Bollinger bands are another technical indicator that goes all the way back to the 1980s. Bollinger bands are similar indicators to those of the Moving averages with an important addition, that of volatility.
This is very important as volatility on the price is a key indicator of whether the trend or possible reversal that you are witnessing is temporary and within reasonable bounds or a more permanent trend change.
Bollinger bands are usually plotted as three lines. There is the middle Bollinger band which is usually a moving average over a specific time period. Then, once the middle Bollinger band has been plotted, two additional lines are drawn which are the upper and lower bands. These are the middle band plus or minus the standard deviation. In the image on the right, we have the 20 period Bollinger bands plotted with 2 standard deviations.
The trader can choose how many standard deviations from the trend they would like to examine for the pair. Taking a look at a quick example, in the graph on the right we have the EURUSD Bollinger bands with a 20 look back period and 2 standard deviations either side of the trend.
The way that traders are able to produce signals based on the Bollinger band is to determine how far away from the trend the price has broken and whether that is reason to enter a trade based on possible reversals.
As a general example, assume that the price had broken above the middle band and had touched the top band. Many traders and algorithms see this top band as a resistance level. Hence, if the price is unable to breach this upper band, it is likely to retrace and is a sign the trader should short. Of course, the opposite can be said for a fall to touch the lower Bollinger band as a resistance and a possible entry for a long position.
On the other hand, if the price manages to break past the upper or lower Bollinger bands then this could be an indicator of a trend reversal and a signal that the trader should enter the position that conforms with the trend. This is just one example of how trading software will use Bollinger bands to derive their signals.
If you are deciding to use Bollinger Band signals to drive your trading, then you would need to take the following precautions before entering trades.
- Never allocate more to a Bollinger Band signal trade than a set amount. This can vary according to the parameters set by the trading software that produces the signal.
- Entry decisions should be based on the choice of standard deviation on the signal. Some signal providers allow you to define the number of standard deviations from the mean you would like signals to be generated on.
- As with the other indicators, entry and exit levels should be based on the prices that were observed over the previous four candles.
- Stop losses are key when it comes to Bollinger band signal trading. The Bollinger bands themselves are also quite helpful when placing stop losses. Usually, one can plot multiple bands and place a number of stops.
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