WHERE STATISTICS AND FOREX MEET
The Bollinger Band is a popular technical analysis tool because it is easy to read, easy to apply, and gives quickly identifiable signals to the trader. In essence, it is a price action volatility indicator.
The center line is a moving average, this is usually either a simple moving average or an exponential moving average over a particular time frame. The upper and lower outer lines represent two standard deviations from the moving average, calculated over the same period.
When the upper and lower bands diverge away from the centerline it is a reflection of the increased volatility of the current market. When the upper and lower bands begin to converge on the center moving average it is a representation of the decreased volatility of the market. This narrowing of the band is called the ‘squeeze’ and often an indication of a future increase in volatility. Conversely, a broadening of the band can indicate a future decrease in the market volatility. However, keep in mind that the Bollinger Ban shows the volatility in the market, it doesn’t indicate time when change will happen nor in which direction.
The two outer bands encapsulate approximately 95% of the market price action, which is a pretty good catch, but there is still the other 5% to consider. A falsehood often believed by novice traders is that when prices touch or breach the upper or lower bands it is a signal to sell (upper band) or buy (lower band). These breakouts are simply signals and should not be taken as a definitive cue to buy or sell, sometimes they’re just the other 5% that didn’t fall within the lines.
The take away message is that the Bollinger Band is great in that it can give a pretty good overview of the condition of the market and its volatility, but it was never intended to be the deciding factor in how to trade. Even John Bollinger himself suggests using the Bollinger Band in conjunction with two or even three other different non-correlated indicators to ensure your trading is based on a more holistic view of market signals.