Forex trading is often reckoned to be an esoteric topic. This is particularly so with respect to the technical analysis aspect of forex trading. If you have a good broker and trading software you do not automatically become a profit making forex trader. You should simultaneously have a proper trading strategy in place to predict accurately future market trends. Bollinger Band is one such tool that helps you to chart a forex strategy by predicting the behavior of currency markets.
Bollinger Bands are in fact a simple technical analysis tool. John Bollinger is credited with the formulation of Bollinger Bands in the early 1980s. At that time it was used in capital markets. Now it finds use in forex markets too. There is volatility and inherent instability in forex markets and this situation is always perceived to be active and dynamic and never ever dormant. Consequently there was a need to find a flexible trading band and it is for this purpose Bollinger Bands are used.
This diagram was taken from this website.
As you can see from the above diagram, Bollinger Bands are made up of a chart of triple curves in accordance with the prices of currency pairs. The upper and lower line indicates the range of price movement. The middle line shows the average price. When the market is volatile something vital happens in the chart. That is when volatility happens, the gap between the upper and lower bands will widen. Now when a bar or candlestick crosses one of the bands it will indicate a currency which is either being overbought or oversold. As you can see from the example above, arrow 1 extends above the upper bands, which is indicative of a buy signal
In technical analysis, usually the outer limits of currency price variations are used to determine if a particular currency is overbought or oversold. Since Bollinger Bands are plotted two standard deviations on each side of the moving average, depending on how close the market average moves to the lower band would determine the extent of oversold conditions in the market. On the other hand, depending on how close the average was to the upper band would determine the extent of overbought conditions in the market.
I guess all this is a bit difficult to understand and so probably needs a bit more explanation. We talked of standard deviation. What is it? In simple terms standard deviation is a measure of volatility and is usually calculated using a historical basis. So you could well understand that, the bands will widen if the data on which it is based is volatile and shrink if the converse is the situation. Simply put, Bollinger Bands will adjust themselves to market conditions and that too especially in volatile market conditions. If the prices break out of the band, you could take it as a turning point.
Therefore to summarize, Bollinger Bands could be used by forex traders to determine overbought and oversold levels in forex currency markets. If for example the price touches the upper Bollinger Band the right thing to do would be to sell and if the price hits the lower Bollinger Band the right thing to do would be to buy. But this is not a hard and fast rule. You have to temper your decisions with your knowledge of fundamental analysis at that point in time.
For a technically oriented forex trader, Bollinger Bands are a vital tool. It gives them that little extra analytical sophistication especially when the market breaks out in a directional movement from range bound activity. Personally I prefer chart patterns and fundamental analysis as my essential trading tools. I consider Bollinger Bands as just one amongst the many trading tools, and I use it primarily to get an insight on currency overbought and oversold conditions in the market. I never use it as a specific indicator of buy and sell signals for any currency pair. Remember that in essence Bollinger Bands help measure deviation and hence they could be very useful in analyzing a particular trend in the forex market. That is pretty simple to remember.