A standard deviation is the measure of the spread of a set of number. Bollinger Bands (BB) is calculated using the standard deviation. The higher the difference between the closing prices and the average price of a currency pair, the larger the standard deviation and the volatility of the currency pair will be. 95% of the recent closing prices are going to be within the two standard deviations of the currency pair price when the markets are ranging. In a range bound market, if the price pops above or below the Bollinger Bands, it does not belong there. It is an outlier.
The formula used to calculate the Bollinger Bands (BB) is: Lower BB= 20 SMA-2(Standard Deviation) and Upper BB= 20SMA + 2(Standard Deviation. There are three different ways you can setup trades using Bollinger Bands.
Range Trading: In a range bound market, Bollinger Bands envelop lines are parallel to each other. You can use the bands to enter or exit a trade and consider trading within the range identified by the Bollinger Bands.
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.
You are seeking opportunities to profit not opportunities to trade! Do not predict a support or resistance level based solely on Bollinger Bands. Once the reversal pattern is confirmed by other indicators, you can place your stop loss on the other side of the Bollinger Band. Wait for the price to bounce first and seek confirmation from other indicators before you enter a trade.
Breakout Trading: Suppose the price breaks above or below the upper or lower band. This is an indication that a breakout and a new trend is about to develop. Seek confirmation by using a momentum indicator such as the 5 EMA/8 SMA cross or a stochastic cross. This will filter out a false breakout. If the price breaks above the resistance on the upper band, enter a long trade. If the price breaks on the downside on the support level, enter a short trade.
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.
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.
