How to Use a Bollinger Band Trading Strategy

There are several trading strategies that can be used to determine the future direction of an asset such as a currency pair. One of the most popular strategies is using a mean reversion strategy such as a Bollinger band trading strategy. Bollinger bands use volatility to see how far an asset price can stretch from its mean price, and helps you evaluate whether the price has stretched too far too fast. If you want to learn about some of the strategies that are commonly used to trade using Bollinger bands, check out the iFOREX education section.

What are Bollinger Bands?

Bollinger Bands, created by John Bollinger, are a technical analysis tool that is used to help determine +the volatility of an asset such as a currency pair or commodity.  Bollinger bands measure the distribution of the price of an asset, by evaluating the standard deviation of the asset beyond a specific average.  The default measurement for the Bollinger band is 2-standard deviations beyond the 20-day moving average.

How is the Bollinger band Calculated?

Most technical analysis charting software packages calculate the Bollinger bands for you. They simply take a default moving average, like a 20-day moving average and added Bollinger bands around it. A 20-day moving average is the average of the last 20-days. On the 21st day, the first day in the calculation is dropped.  During that 20-day period, the standard deviation of those data points is added and subtracted to the moving average, generating a Bollinger band high and a Bollinger band low.

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In the EUR/USD chart above, the black arrows points to the Bollinger band high and the Bollinger band low. Bollinger bands can also be flexible. While the default is the 20-day moving average and 2-standard deviations around that mean, you can use any moving average with any unit. For example, you could choose the 30-week moving average or the 50-hour moving average. The standard deviation is also flexible. Two standard deviations reflect 95% of all the data points in the time series.  If you use 3-standard deviations you encapsulate 99% of all the data points, while 1-standard deviation encapsulates 66% of all the data points.

How to you Trade Using Bollinger Bands?

There are several ways to use Bollinger bands to trade the capital markets. One of the most popular ways is to use a mean reverting strategy. A mean reverting strategy is one where you purchase an asset when the value moves to the Bollinger band low and sell the asset when the value reaches the Bollinger band high.  For example, in the chart of the EUR/USD you could sell when the exchange rate reaches the Bollinger band high (the red arrow) and purchase the currency pair when the exchange rate reaches the Bollinger band low (the green arrow).

Summary

Bollinger bands are a technical analysis tool that can be used to help you determine if the market has moved too far too quickly. The Bollinger bands are calculated to by adding a specific standard deviation to a certain moving average. The default is the 20-day moving average and 2-standard deviations. A typical trading strategy is to buy an asset when it reaches the Bollinger band low and sell the asset when it reaches the Bollinger band highs.