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Currency Trading Analysis: Applying Bollinger Bands, An Absolutely Necessary Device For Technical Foreign Exchange Traders
Bollinger bands on currency trading charts are used just as on equities and options trading charts, as an indicator to alert the trader to a new unfolding movement, breakout or trend. They are made up of three lines or bands.
The central band is a simple moving average over a specific number of periods, usually 20. The upper and lower lines are at a certain number (usually 2) of standard deviations calculated with reference to the number of intervals used for the center band.
Bollinger bands were invented by John Bollinger in the 1980s. The reasoning behind them is that prices will normally alternate within 2 standard deviations of the average, which here is the moving average used to plot the middle line. This means that as prices reach the upper and lower band lines, a reversal is signaled to keep the prices within the bands.
They are also an indicator of amplitude. Wider bands signal a more volatile market than narrow bands.
Traders use Bollinger bands in several different ways but these are the two most widespread ones:
1. Identification of overbought and oversold market conditions
On the basis that prices are likely to stay within the bands, several traders will use Bollinger bands as an indicator to sell when the price soars above the upper line and buy when it dips below the lower line. Normally they will plan to close their position when the price approaches to the central line.
Preparedness is required here, however, as these movements outside of the bands may just indicate a powerful trend forming in that direction. So you could be stuck on the wrong side of a powerful trend in some cases. John Bollinger himself recommended frequently examining against another indicator. Presumably the best for this function are non-oscillating indicators such as trend lines or chart patterns.
2. Identification of contraction and foretelling breakout
As we have seen, the bands will diverge and converge according to the volatility of the market over the measured past intervals. When they converge so that their area becomes narrow, this is called contraction. Some traders will act on the basis that contracting bands is a signal of a large breakout and place both buy and sell orders outside the bands.
The risk here is that there can often be a misleading break where the prices will stretch outside the bands briefly prior to reversing. Because of this reason some traders prefer not to act on the first move outside the bands. Again you should always check against another indicator on your forex charts, or use forex signals as a checking tool. A forex signal is a market forecast and a trading recommendation, which can be used as a confirmation, especially if comes from a reliable forex signal provider.
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