Using Bollinger bands to discover the difference between volatility and volume…
Bollinger Bands are a pair of lines that track price on a chart, running roughly parallel to one another when price is stable and expanding or moving apart when price is volatile. Usually a midline is also displayed at the halfway mark between the two outer bands. The following chart shows the idea:
Bollinger Bands Map Trends and Volatility
This forex trading indicator is extremely powerful when used properly. So, how to use Bollinger Bands?
This is what the Bollinger Bands indicator tells us:
Although not strictly a mere trend indicator, Bollinger Bands can indicate a change in trend due to the way they track current price. The information is LAGGING, but it is useful.
If price is in the lower half of the channel formed by the Bollinger Bands – in other words below the midline – we can assume a mild bearish sentiment. If it is in the upper half of the channel will you may conversely assume a mild bullish sentiment. If price is in either section of the channel and the Bollinger Bands are expanding, the sentiment can be assumed to be stronger.
This is simply a measure of how much the bands are stretched or expanding – when volatility is high – or contracting when volatility is low. The illustration above clearly shows the elliptical shape the bands take on during a price surge (at the left of the illustration).
Once again it’s after the fact information, but this feature of the Bollinger Bands can be very useful when volatility variations are not so pronounced. In these situations expanding bands can give supplementary indication of increasing volatility, and contracting bands help to show us that volatility may be settling down.
This one is not so clear cut. When the bands expand greatly we can see that volatility has spiked. But what about volume? There are two things to note. One is that if the spike occurred around a news announcement, this probably indicates low volume, as a great many traders would not be in the market at this time, preferring to stand aside until the announcement had been made. This means that if the announcement is unexpectedly bearish or bullish, price will surge through an area of thin trade orders – in other words low volume.
On the other hand, we have the situation where a price spike occurs without any scheduled news announcement occurring. Perhaps some shock news hits the market. In this scenario many traders may be caught with their orders still in the market. Hence price will still surge, but it has to “eat” its way through a greater volume of orders to get to where it is going.
One final thing to note on the topic of volume is when price spikes noticeably and then retreats, leaving a long wick. This can be seen happening at the right of the illustration above. Note carefully that in this case the Bollinger Bands did not expand very much, in contrast to the price action at the left of the illustration.
Even though price covered roughly the same distance, in this case we might assume that due to low numbers of orders on the buy side, price failed to go on with the job. However, although it may indicate low volume of trades at this time, equally it could be said to indicate high volume due to a large number of sell orders coming into the market in response to the price surge. Interesting, yes?
I use Bollinger Bands in two of my forex trading strategies: the Bladerunner and the Bolly Band Bounce strategies.
When using Bollinger Bands In the Blade Runner, I substitute the midline band for the 20 EMA. This strategy can use either Bollinger Bands or the 20 EMA. To be perfectly honest, I can’t decide which works better and I often switch between the two to experiment. It works perfectly well either way. However, the Bollinger Bands give extra information with respect to volatility, as noted above.
When using Bollinger Bands In the Bolly Band Bounce strategy, I scalp off price reaction at the outer Bollinger Band. More details available in the Forex Trading Strategies section.
There are many systems and strategies based around Bollinger Bands, as it is an extremely popular forex trading indicator that has proved its worth over time. Although the information it conveys regarding volatility and trend is lagging, it is very useful in strategies where it’s on chart nature can be used to pinpoint trade entries and exits in real time.
For more details on the technical aspects involved in Bollinger Bands go to John Bollinger’s Website