Technical analysis is an inevitable part in forex trading. Forex traders greatly rely on many technical analysis tools to smoothen their trading decisions. Bollinger bands is one such tool that makes a trader’s day easy. Discovered by John Bollinger in the early 80’s, Bollinger bands are best known to be used in comparing the stock price volatilities. These bands work on the theory of moving averages and provide a relative comparison between the high & low volatility.
Bollinger bands, as the name suggests, comprise of three bands to evaluate the stock’s price trends. The upper band shows the price trends when the stock is bullish, the lower band shows the price trends when the stock is bearish and the middle band shows an intermediate trend of the price. The middle band is based on the moving average theory, which is a platform for the trend determination in the upper and the lower bands. The difference between these bands is nothing but the volatility of the price. The upper and the lower bands are a combination of the moving average and the standard deviation. Standard deviation techniques are good analytical tools to determine the price’s volatile movements. When there are large price fluctuations, the distance between the bands widen. John Bollinger suggests a 20-days moving average for the middle band and relative +/- 2 standard deviation for the upper & lower bands.
A Bollinger band strategy is not the base to decide on the exact point to deal in the stock. But the bands are rather used to study the stock price volatility. When there is huge volatility, the distance between the bands widens. When the volatility of the price starts building up, the stock price may be seen closer to either of the upper or the lower band. A trader may apply a trading strategy after correlating the width between the bands to the length. Lesser the distance, lesser the survival chances of the volatility. When the price starts distancing itself from the upper or lower band and moves towards the middle band, a trader can breathe at ease now that the volatility has reduced.
Bollinger band strategies are well known to be implemented to take advantages from the price volatility. Don’t know how? I will explain now! Always mind that Bollinger bands are never used solely for trading decisions. Other analytical tools are used along with Bollinger bands. When a stock is sold heavily, the price slides itself towards the lower band. Following a heavy selling, breaks can be seen in the lower band. After this the price will start moving towards the middle band. Here is where a trader can take advantage. When the price shows signs of closing below the lower band, the trader should trace this signal. When the stock opens at that lower price the next business day, he can buy the stock at that price.
Sometimes the stocks continue to sell heavily below the lower band and the selling pressure is not rectified. In such scenarios, the stock continues to trade on much lower prices than expected. At this time, the best way would be to exit the stock.