The Bollinger bands theory was propounded by John Bollinger who formulated this very useful trading tool that builds upon the propensity of bands to expand and contract representing the volatility of forex markets and price behavior. It is based on standard deviation, a statistical tool that traces the relative deviation of a simple average to a maximum and a minimum limit.
Similarly, this trading tool makes use of a simple moving average with its corresponding higher and lower bands that will either expand or contract according to price movements in relation to the average. Traders in most cases use a 20-day average as the middle line or average, and study price movement trends, upwards or downwards, in relation to the 20-day average.
The Bollinger Squeeze is a phenomenon that predicts a major change in the direction of a price movement. The upper and lower bands are the closest to the average middle band on account of meager price movement during the trading period (open and close). However, when price action breaches and subsequently breaks out of a band (upper or lower), it indicates a new price trend. For e.g. if the price breaks out of the upper band then it indicates an upward trend after the gloomy trading period.
On the other hand, if the price breaks out of the lower band, it indicates a downward trend. Fundamentally, another way to look at it is to correlate the gap between the two bands with the length of the bands in a time period. The rule of thumb is that the closer together the bands are, the shorter will be the time that they stay close together.
For a trader, this is a signal that a major price trend reversal in on the cards. When the upper and lower bands are farther apart, it indicates a more volatile market implying a greater propensity for the price action to fall towards the average. However, in many cases the price has also exhibited a jump away from the average when the upper and lower bands expand.
An interesting behavior of Bollinger bands is the “Bollinger Bounce”. According to this, the price movements will eventually always return to the middle band (average) which is because of the balancing act played by the support and resistance levels at each maxim (upper and lower band). These bands therefore indicate a price movement trend. Let us further elaborate on the same.
The greatest disadvantage of the Bollinger bands is its inability to indicate the most suitable phase in a price action trend movement to open or exit a trade or even to initiate buying or selling a currency pair. It only acts an indicator of the trading price volatility. It can only help predict a possible trend and even make a calculated guess on when to expect an anticipated change.
The Bollinger bands work on three bands- upper, lower and a moving average band. The price fluctuates above or below the moving average indicating volatility in the forex market suggesting price behavior behind a currency pair. The narrowing of the upper and lower bands indicates the likelihood for a major price trend change.