How To Use Bollinger Bands? (Part II)
Standard deviation is the measure of the spread of a set of number. The larger the difference between the closing price and the average price, the higher the standard deviation and the volatility of the currency pair. When the markets are range bound 95% of the recent closing prices are expected to be within the two standard deviations of the currency pair. In other words, in a range bound market, if the price pops above or below the Bollinger Bands, it does not belong there.
Lower BB= 20 SMA-2(Standard Deviation). Upper BB= 20SMA + 2(Standard Deviation. This formula is used to calculate the lower and upper Bollinger Bands. There are three different ways you can setup trades using BB.
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.
When the price reaches the upper band, the market is considered to be overbought. When the price touches the lower band, the market is considered to be oversold. However, when the price touches the upper band or the lower band, it in itself is not a trading signal.
Do not predict a support or resistance level based solely on Bollinger Bands. You are seeking opportunities to profit not opportunities to trade! Wait for the price to bounce first and seek confirmation from other indicators before you enter a trade. Once the reversal pattern is confirmed by other indicators, you can place your stop loss on the other side of the Bollinger Band.
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: When you see the Bollinger Bands becoming tight and narrow, expect a breakout to occur in the near future. The longer and more narrow the Bollinger Bands, the greater the breakout will be. Pay attention! This is only true between the times 5 A.M to 5 P.M London Time.
When tunnels are created during the odd hours of currency trading, it simply shows that no one is trading at that time! Most of the traders are out and a breakout is not likely to happen until the traders return to their charts. This is also known as the, Bollinger Band Squeeze. The Bollinger Bands spread further apart and is an excellent indication to plan a trade. When a breakout happens, a new trend is started.
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