Optimize Your Forex Trading

Tuesday, October 9, 2007

Bollinger Bands (BB) is among the most powerful economic indicators in the foreign exchange market. Invented by John Bollinger in 1980's; the bands are simply measuring the highness or the lowness of the current price of an equity or a currency pair relative to previous trades. Technically speaking, that is to measure the standard deviation from the moving average. In order to explore the premise behind the bands, let’s first see the band’s three main components.

BB STRUCTURE:

1) A middle band represents a 20 period SMA
2) An upper band represents the 2nd standard deviation above the middle band
3) A lower band represents the 2nd standard deviation below the middle band
The rationality behind the Bollinger Bands is that the upper BB would act as a resistance level and the lower BB would act as a support level. When the price of a currency pair touches any of the two bands, it’s highly likely that the pair will retrace toward the moving average in the middle of the bands. This means that BB will perform only at a range bound market and not at a trending market.

Suggested Strategy:

1) Traders need to identify a range bound trading market (higher lows and lower highs)
2) When the price of a currency pair hits the upper BB, traders may place a short position after the formation of a bearish candlestick pastern
3) When the price of a currency pair hits the lower BB, traders may place a long position after the formation of a bullish candlestick pattern
4) In the two cases, traders may make their target at the middle BB band
5) Protective stops would be placed at a reasonable distance above the upper band (in the short trade), or below the lower band (in the long trade).