The vast majority of the time, exchange rates on the forex markets move within a certain “range”. That is, although prices rise and fall, they constantly remain within a certain range. This range is often determined by support lines and resistance lines (about which you can read in Lesson 8 of the forex course for beginners). The range within which a currency pair moves is important for predicting the price development.
Recognizing the range in a Forex chart
An example of a ranging currency pair is shown in the chart below. It is the one-hour chart of the AUD / USD. You can create a similar chart with the trading software of Plus500, IG, or Markets.com. You can choose a trading instrument, set the time frame you want, and add technical indicators to the chart. As can be seen in this example, the price is moving between the two light blue lines: the range. Apart from two upward peaks at the beginning, the range is actually even narrower (the dark blue line at the top).
If you encounter a chart like the one above the currency pair is “ranging”. In that situation, Bollinger Bands are a useful instrument to predict future price movements.
“Bollinger Bands” is a trading instrument for technical analysis in the forex market. Bollinger Bands measure the standard deviation of the exchange rate relative to the moving average over the past 20 periods (candles). The standard deviation measures how much the price fluctuates around the mean. A large standard deviation indicates a large price fluctuation; standard deviation indicates a minor price fluctuation. The upward and downward standard deviation is drawn in the chart as two bands above and below the moving average in the price chart. If there is high volatility the Bollinger Bands are wide; they get narrower as volatility decreases.
With the Plus500 trading software you can automatically add Bollinger Bands to your chart. Simply choose “Bollinger Bands” from the indicator list. The standard is to take a moving average of 20 periods for the Bollinger Bands, and to use the bandwidth of two standard deviations. The reason for this is that 95% of the time the price moves within two standard deviations of the mean. Bollinger Bands thus clearly indicate exceptional situations.
You can customize the analysis, simply by using different values. More standard deviations cause wider “bands”. This makes the signals more reliable but it also increases the chances that you’re missing out on profitable trades. More periods not only result in wider, but also in more smoothed bands that less accurately follow the price trend. That is usually not beneficial for the prediction power, so it is recommended to just use the standard 20 periods.
Using Bollinger Bands
Bollinger Bands are valuable to show if a currency pair is overbought or oversold. If the current price is at or above the upper Bollinger Band of a ranging currency pair, this means that it is at the top of the range with respect to the fluctuation within the past 20 periods. This could mean two things: it is either the beginning of a trend in which the currency pair is going to move up, or the currency pair is overbought. In the same way a currency pair, the price of which is at or below the lower Bollinger Band, is either at the start of a downtrend or is oversold.
Since currencies usually remain within the range, there is a large probability that the price hitting the Bollinger Bands indicates either over- or undervaluation. The width of the Bollinger Bands, however, is important to consider. A breakout from the range is often preceded by lower volatility (and therefore narrow bands), because the upward and downward forces keep each other in equilibrium. In this situation, the Bollinger Bands are less suited to open a range-trade (but even more so for a breakout trade). If the bands are wider, a breakout is less likely and the bands are a useful indicator for range trades.
This principle is easy to implement in your forex strategy. When (in case of wide bands) the price of a currency pair exceeds the upper Bollinger Band and then again touches the band downwards, that is a signal that the price will probably go back to the lower band. At this moment you could open a short position. In the opposite way it could be a signal for a long trade.
The chart above displays how the Bollinger Bands function in a ranging market. It is the 1-hour graph of the USD/JPY. At the moment of this screenshot the market moves sideways within a pretty narrow range of about 100 pips. Every circle indicates a buy signal based on overvaluation or undervaluation.
Target price and stop loss
Every time the price enters the range of the Bollinger Bands you open a position in the direction of the moving average. You hold this position until the price moves to 10 pips from the opposite Bollinger Band. At that point you exit the position because the valuation deviation has changed to the other side. Next, you wait if the other Bollinger Band is crossed and if that is the case you open a contrary position if the enters the range again.
The currency pair does not always move back to the opposite Bollinger Band. Sometimes it slips further which could be an indication of a new trend. In order to protect yourself against this, you set a stop loss. In the chart of the example you could set a stop loss of 20 pips for example. If the price than does not move into the direction you had projected you only lose 20 pips, while in case of a successful trade you make 40-60 pips on average.
In the graph the positions at circles 2, 3, 9, 10, and 11 are resulting in a loss. At each of these trades the prices first makes a loss of 20 pips before the price target is reached. This is caused either by the price “sticking” to the Bollinger Band too long, or because it bounces back from the moving average instead of from the opposite band. In these cases you do not open a new position at the moment the same Bollinger Band from the previous trade is hit. You first want confirmation that no trend has started and that the market is still moving within the range; therefore, only open a position when the opposite band is hit.
You should take into account that a portion of the trades you open based on the Bollinger Bands will result in a loss. In the previous example you lose 5 out of 12 trades. Therefore it is important never to put a large part of your trading capital in one trade. Eventually, the majority of the trades will be profitable, and through a decent choice of the stop loss you will earn more on a profitable trade than on a losing trade. In this way you can make money on the long term with this strategy.
In the example chart it is doubtful whether, after position 12, the currency pair still moves within a range or has started a downward trend. The moving average is only moving downwards. Because the Bollinger Band strategy that we discuss here only works in a range-bound market, it is recommended not to open any positions when a trend seems to be forming. It is thus important to keep monitoring if the requirements for this strategy are still there (a ranging market and wide bands).
Bollinger Bands and other indicators
To conclude, we advise you to always test your buy signals based on Bollinger Bands on other indicators as well. A signal is much stronger if it is generated by multiple independent instruments, then when it is solely based on Bollinger Bands.
Do you want to try the Bollinger Band strategy yourself? You can do so with the advanced trading software of Plus500. With this software you can easily apply the Bollinger Bands to any chart and trade based on this indicator. Besides, Plus500 offers a wide range of other technical indicators, which are explained in the Plus500 trading tutorial. Open your account with Plus500 here.
This article is part of the “Forex technical analysis strategies for advanced traders” series. Continue reading the next article “Pivot point forex trading strategy“