Bollinger Bands are popular with technical analysts and traders in all markets, including forex. Since traders of currencies look for incremental price moves for profit, recognizing volatility and trend changes quickly is essential to having a successful strategy that will net profits.

Forex trading is one of the most prevalent trading markets in the world, with much more activity than the stock market itself. The premise lies in taking advantage of the slight changes in exchange rates, which allows a trader to generate profits by buying and selling different currencies at a beneficial point in price. The theory works the same as trading any asset. If a trader expects the price of a currency to go up, they will buy the currency. If they expect the price of the currency to go down, they will sell the currency.

Bollinger Bands

Bollinger Bands are a form of technical analysis that traders use to plot trend lines that are two standard deviations away from the simple moving average price of a security. The goal is to help a trader know when to enter or exit a position by identifying when an asset has been overbought or oversold. Bollinger Bands were designed by John Bollinger.

Bollinger Bands help by signaling changes in volatility. For generally steady ranges of a security, such as many currency pairs, Bollinger Bands act as relatively clear signals for buying and selling. This can result in stop-outs and frustrating losses, though, so traders consider other factors when placing trades in relation to the Bollinger Bands.

Setting Limits

First, a trader must understand how Bollinger Bands are set up. There is an upper and lower band, each set at a distance of two standard deviations from the security's 21-day simple moving average. Therefore, the Bands show the volatility of the price in relation to the average, and traders can expect movements in price anywhere between the two bands. Forex traders can use the bands to place sell orders at the upper band limit and buy orders at the lower band limit. This strategy works well with currencies that follow a range pattern, but it can be costly to a trader if a breakout occurs.

Reading Volatility

Since Bollinger Bands measure deviation from the average, they react and change shape when price fluctuations increase or decrease. Increased volatility is nearly always a sign that new normals will be set, and traders can capitalize using Bollinger Bands. When the Bollinger Bands converge on the moving average, indicating lower price volatility, it is known as "the Squeeze." This is one of the most reliable signals given by Bollinger Bands, and it works well with forex trading. A Squeeze was seen in the USD/JPY currency pair on Oct. 31, 2014. News that the Bank of Japan would be increasing its stimulus bond-buying policy sparked the trend change. Even if a trader did not hear about this news, the trend change could be spotted with the Bollinger Band Squeeze.

Backup Plans

Sometimes reactions are not as intense, and traders can miss profits by setting orders directly on the upper and lower Bollinger Bands. Therefore, it is wise to determine entry and exit points near these lines to avoid disappointment. Another forex trading strategy to work around this is to add a second set of Bollinger Bands placed only one standard deviation from the moving average, creating upper and lower channels. Then, buy orders are placed within the lower zone and sell orders in the upper zone, increasing execution probability.

There are several other specific strategies used in currency trading with Bollinger Bands, such as the Inside Day Bollinger Band Turn Trade and the Pure Fade Trade. In theory, these are all profitable trades, but traders must develop and follow the methods exactly in order for them to pan out.

The Bottom Line

Bollinger Bands can be a useful tool for traders in assessing the volatility of their position, providing them with insight on when to enter and exit a position. For forex traders, certain aspects of Bollinger Bands, such as the Squeeze, work well for currency trading, as does adding a second set of Bollinger Bands. Using this tool correctly can help investors and traders make better decisions and hopefully earn profits.