Lesson 2: Bollinger Bands

Bollinger Band® Volatility and Rate Reversal Signals

Overview

  • Volatility describes the degree by which an exchange rate varies over time.
  • Forex traders pay close attention to volatility as volatility tends to increase just prior to a rate reversal. As the reversal gains in momentum, volatility tends to sharply increase as traders act to take advantage of the change in direction.
  • Bollinger Bands show relative volatility changes through the width of the bands themselves - the wider the bands, the greater the volatility.
  • In the following example, you can see that at the far left of the chart, the upper and lower bands are close together and are near the moving average line.
  • By the 16:55 mark however, they start to widen and the rate also begins to climb at this point until it reaches a peak and then falls.
  • The exchange rate then flattens out and the upper and lower bands begin to move closer together indicating that volatility has subsided.


Candlestick Chart with Bollinger Band overlay
Sample Candlestick Chart with Bollinger overlay

Using Bollinger Bands to Signal Trend Reversals - Breaking the Bands

  • When the spot rate falls outside the bands, it is said to be "breaking the bands".
  • Breaking the bands occurs during times of extreme volatility and is the strongest signal issued by Bollinger Bands that a trend reversal is imminent.
  • As we learned earlier, two standard deviations include about 95 percent of all data for a normal data pattern. Therefore, market rates should only break the bands about five percent of the time when viewing two standard deviations.


Rates breaking Bollinger Bands
Rates Breaking the Bands

Three consecutive closes breaking the sell band. Together with the increasing volatility, this is a signal that the rate is about to reverse making this a good "buy in" point.

  • Traders use the terms "over-bought" to describe the situation where spot rates break the buy band, and "over-sold" when spot rates break the sell band. Both are acknowledged as market reversal signals.
  • In the example above, you can see that the AUD/USD currency pair was trending downwards until the point where three consecutive closes break the sell band barrier just after the 10:20 time period.
  • This is a strong reversal signal that identifies a possible "buy-in" point.

Double Tops and Double Bottoms

  • The existence of price chart patterns such as double tops and double bottoms can help identify buy and sell opportunities.
  • When a rate reaches the highest level that the market is willing to pay - that is, the resistance level - the rate usually holds at the level creating a second plateau more or less equal to the previous level. This is the second part of the double top and if the rally is to be extended, the second top may be slightly higher.
  • If the subsequent top is lower, this is seen as a signal that a rate reversal is imminent as traders sell their positions or short the currency pair outright in anticipation of a drop in the exchange rate.
  • A double bottom is basically the same as a double top but is seen as a signal that the support level for an exchange rate has been reached resulting in an increase in the rate.
  • This is because once the market is prepared to support the rate from dropping further, buyers enter the market in an attempt to buy into the currency pair at a low point prior to an upswing.


Bollinger Bands showing double-top and double-bottom
Sample Candlestick Chart with Bollinger overlay

  1. After several closes below the support level, the exchange rate reversed its direction shortly after posting a double-bottom

  2. A double-top signified the end of a series of intra-period closings above the top band (the resistance level) indicating a rate reversal.

For more information on price chart patterns including "double-tops" and "head-and-shoulders" patterns, see Recognizing Bar Chart and Line Chart Patterns in Lesson 6 of A Concise Introduction to Currency Trading.

This is for general information purposes only - Examples shown are for illustrative purposes and may not reflect current prices from OANDA. It is not investment advice or an inducement to trade. Past history is not an indication of future performance.

Trading FX and/or CFDs on margin is high risk and not suitable for everyone. Losses can exceed investment.