A Bollinger Band is a simple technical analysis tool which indicates an imminent reversal from the current trend.
How to Trade a Bollinger Band Reversal Strategy:
A Bollinger Band is an indicator which takes a 20 period simple moving average which defines the intermediate term trend of the price and also uses two standard deviations of the instrument being traded to work out the width between the simple moving average and the bands. The top band is plus 2 deviations above the middle line (moving average) and the bottom band is minus 2 deviations below the middle line (moving average). The bands are not support or resistance levels such as those derived from pivot points and there is no calculated data that says that prices should stay within the bands. However, most of the time the prices do stay within the bands and this is something that the trader can use to trade Bollinger Band strategies.
Traders who use the traditional technical analysis on candlestick charts like double bottoms and tops, head and shoulders patterns and other candlestick patterns can strengthen their analysis by using the Bollinger Bands indicator. Bollinger Bands can help traders understand where the price is going. Is it trending, is it ranging or is it volatile. When the bands are very close together the asset is trading in a range that is very narrow and when the bands are far apart this indicates volatility, price breakouts and large rallies.
In the chart above notice how from 06:55 to 08:55 the upper and lower bands are close together and very near the line of the moving average. After 08:55 the bands start to widen and move away from the moving average line as the currency price becomes more volatile and a trend begins to develop.
If the asset price drops outside of the bands either below the lower band or above the upper band the price is considered to be ‘breaching the bands’. This happens during times of extreme versatility and is the signal given out by Bollinger Bands is that a reversal in trend is impending. As the outer bands are two standard deviations from the moving average this means that 95% of the time the price will stay within the band limits and 5% of the time the price will breach the outer bands.
The Bollinger Band reversal strategy is a very simple yet effective strategy for a forex trader to have in his tool kit of strategies. Where two or more candles close above the upper band or two or more candles open below the band then this usually is a strong signal that there is an imminent reversal.
The GBP/USD 5 minute price chart below displays three such breaches of the outer Bollinger Bands.
The first instance of a reversal (the blue circle) did not have a strong signal as the green candle closed above the line and the red candle below the line, however there was a small reversal. At 10:55 the chart showed three closes in a row (red Circle) above the upper band, a very strong signal for a reversal. The trend reversal lasted until 12:20 when the underlying upward trend continued. Around 13:00 the chart shows two things. Firstly we have two candles closing above the outer band and secondly a typical tweezer candlestick pattern (green circle) confirming the imminent reversal. Although the total pips profit from these three reversals was around 60 pips it still would have been a very profitable series of trades for a day trader. Bollinger Bands can be used on any timeframe with equally good results.
Are you using forex social indicators to make your investment decisions? Social indicators are based on real trades made by thousands of different traders. eToro Openbook is the largest social trading network and provides you with live trading information to better form your investment decisions. Visit eToro Openbook and start using social indicators today!