Currency Trading Charts and Bollinger Bands

Bollinger bands were created to determine patterns in more volatile markets. They are used to help the investor anticipate new trends or movements in the market. Bollinger bands, which are comprised of three lines, can be used with foreign currency trading, as well as in the stock market.

The central line on a chart with Bollinger bands indicates a moving average over a length of time, usually 20 periods. It is a base for the two other lines. The lines above and below the central line are determined by market volatility and are calculated using the same data that gives us the average with a typical standard deviation of 2.

Created by John Bollinger in the 80s, Bollinger bands work on the premise that stock or currency prices are usually within two standard deviations of the average, so prices are apt to fall in the area between the upper and lower bands. When prices either reach either top or bottom bands, it alerts traders to a possible reversal that will keep prices in the confines of the bands.

When markets are more volatile, the bands are wider and allow for more movement and fluctuation.

Bollinger bands are most commonly used in the following manners:

1. To identify oversold and overbought markets.

If investors work on the assumption that currency prices will stay within the bands, they can use Bollinger bands to time trades. Many choose to sell when the prices close above the upper band and buy when they close below the lower line. If the prices return to the center or average line, they close their trade.

It is important to remember, though, that when prices move outside of the bands, it may signal the emergence of a new trend. It is possible to miss this and be stuck holding currency that is tanking or fail to buy currency that is rising. As always, it is best to use a variety of indicators, especially those that are non-oscillating. Checking the Bollinger bands against chart patterns or trend lines will give you a more complete overview of the market.

2. To identify when markets will contract and anticipate breakouts.

The bands converge (become narrower) or diverge (become wider) depending on how volatile the market is. Contractions are when a currency or stock value declines from its high point by 10% or more. On Bollinger band charts, this is seen as the area between bands becomes narrower. Many traders see this as evidence of a breakout, meaning prices will go above or below the bands. They place buy and sell orders outside the parameters of the bands in order to capitalize on the breakout.

This is not risk-free, however, because it is possible for false breaks to form. Prices will bounce above or below the bands for a short period and then reverse. Many traders opt to wait before placing orders until they see more than one move outside the band lines. It is always important to check other indicators against the Bollinger bands before making a trade.