Bollinger Bands are based on the standard deviation. A standard deviation is the measure of the spread of a set of number. The higher the difference between the closing prices of a currency pair and the average price, the larger the standard deviation and the volatility of the currency pair. 95% of the recent closing prices are expected to be within the two standard deviations of the currency pair when the markets are range bound. In a range bound market, in other words, if the price pops above or below the Bollinger Bands, it does not belong there.
The formula used to calculate the Bollinger Bands (BB) is: Upper BB= 20SMA + 2(Standard Deviation) and Lower BB= 20 SMA-2(Standard Deviation. There are three different ways you can setup trades with Bollinger Bands.
Range Trading: These envelop lines or bands are parallel to each other when the markets are range bound. The Bollinger Bands have identified a range within which you can consider trading. You can use them to enter or exit a trade.
Suppose the price reaches the upper band. The market is considered to be overbought. Suppose the price touches the lower band. The market is considered to be oversold. However, it in itself is not a trading signal when the price touches the upper band or the lower band.
You are seeking opportunities to profit. You are not seeking opportunities to trade! Trade without profit should be avoided at all cost. Once the reversal pattern is confirmed by other indicators, you can place your stop loss on the other side of the Bollinger Band. Do not predict a support or resistance level based solely on Bollinger Bands. Wait for the price to bounce first. Seek confirmation from other indicators before you enter a trade.
Breakout Trading: A breakout and a new trend is about to develop when the price breaks above or below the upper or lower band. Seek confirmation by using a momentum indicator. You can use a 5 EMA cross or an 8 SMA cross or a stochastic cross to confirm the Bollinger Bands indication. This will filter out a false breakout. Enter a long trade when the price breaks above the resistance on the upper band. On the other hand, enter a short trade when the price breaks on the downside on the support level.
Tunnel Trading: Expect a breakout to occur in the near future when you see the Bollinger Bands becoming tight and narrow. The greater the breakout will be the longer and narrower the Bollinger Bands are. Now pay attention! This is only true between the times 5 A.M to 5 P.M London Time.
Tunnels during the odd hours of forex trading simply show that no one is trading at that time! A breakout is not likely to happen until the traders return to their charts. This is also known as the, Bollinger Band Squeeze. When a breakout happens, a new trend is started and the Bollinger Bands spread further apart. This is an excellent indication to plan a trade.
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