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There are many different ways to trade forex, but the one thing that all traders have in common is their reliance on data and charting. While new techniques are constantly being developed, some methods that have been around for many years remain as popular as ever.
Bollinger Bands® have been around for more than 20 years but remain one of the best ways to track volatility in the market. Understanding the degree of volatility is essential as it can often be an indicator of a trend about to reverse or a swing in direction.
Bollinger Bands® work by tracking the moving average, creating a channel by placing both upper and lower `bands` on the range. The use of either a pricing chart or a candlestick chart to create the channels and calculate a smoothed moving average is required. However, Bollinger Bands® offer more than just a moving average price; the calculations include a deviation both above and below the line, which helps to identify support and resistance boundaries.
In order to effectively use Bollinger Bands®, a trader does not need to know how to calculate the standard deviations; simply being able to read and understand the channels is sufficient. When the price is above the moving average (but still within the channel) it is deemed as a buy signal, as the general momentum is upwards. Conversely, when the price drops into the channel below the moving average, traders can expect to see it start to drop and should sell.
As mentioned above, the bands display the volatility in the market, as well as providing an indication of the likely price direction. This is achieved by the width of the channel. Generally speaking, the broader the band, the greater volatility is present. This can be an indicator of a market about to break out or reverse.
One of the strongest trend reversal indicators that can be seen on this type of chart is a price that breaks through the channels, going either higher or lower than the standard deviation. It is estimated this only happens in about 5% of trades and is a very marked sign that there is about to be a new trend developing.
It is possible to set your own parameters around both the moving average and the number of standard deviations used to create the channels. The majority of charting software is flexible enough to allow each trader to customize it according to personal preference. However, the creator of the bollinger band, John Bollinger, was a firm believer that 20 separate reporting periods to calculate the moving average and two standard deviations to create the channels was the optimum combination.
Anyone who wants to trade forex will most likely come across the use of bollinger bands very early on in their experience. Although there are a number of more complex and more modern methods that can be used today, bollinger bands still offer a simple yet effective way to track volatility and trends in a live market.