The idea of Bollinger Bands Technical Indicator (BB) is similar to MA envelopes, which were discussed in the previous chapter, and are used to identify the optimal points of opening position on Forex and other financial markets. Unlike MA envelopes, Bollinger Bands are well applied for the volatile market analysis.
Bollinger Bands represent two envelope curves, standing at a certain distance from the MA curve. Though, this distance is not fixed, like in the case with MA envelopes, but is equal to the value of the standard (meansquare) deviation, multiplied by a certain coefficient. Standard deviation is a mathematical measure and is, in its turn, a quadratic root of dispersion. These notions are directly connected with the theory of probability and mathematical statistics, and their detailed analysis goes beyond the limits of education on Forex informational portal.
Trading platforms plot Bollinger Bands automatically, but the inquisitive reader can get acquainted with the formula for [http://en.wikipedia.org/wiki/Standard_deviation standard deviation] calculation.
The mathematical formula for Bollinger Bands plotting is:
BB = MA ± k * stdDev,
where MA is a moving average, stdDev –is a standard deviation, and k –is a coefficient of the standard deviation.
Any type of MA can be employed, but more often simple moving average is used. According to the theory of probability, if in both directions from the average the intercepts, equal to the standard deviation, are plotted, not less than 68.26% of the random variate will get along the formed line. If the intercepts, equal to double standard deviation, are lined from the average, not less than 95.44% of the values will get into this interval. For the triple standard deviation, this number increases to 99.73% of the values. These statements are true, if the averages have normal distribution, which can be, to some extent, applied on Forex market.
Forming Bollinger Bands, the standard deviation coefficient k equal to 2 is used more frequently.
With the coefficient equal to 2, around 95% of all prices get into the price diapason, limited by the curving lines. Bollinger Bands can be employed on volatile market since the value of the standard deviation, which is the major at construction, takes into account the speed of the price change. For calculating the value of the standard deviation, it is necessary to choose the value of the counting period. The same value, like for the MA smoothing coefficient, is used, as a rule. Bollinger bands indicator has some interesting features for analysis. If the prices vary within the horizontal diapason, and there is no definite trend at Forex, the band squeeze happens. If a new trend starts to generate, the bands begin to move aside. The longer the bands were inside the horizontal diapason, the stronger the next break with a new trend generation will be, and the faster the bands will move apart.
For Bollinger Bands everything that is applied for MA envelopes is true. That is, the prices should tend to the average. Touching and crossing the higher or the lower curving line denotes the excessive deviation (overheating of the market), and is likely to be accompanied by correctional movement towards the average. In this situation, the roll-back more often is not less, than the MA measure. The exception is, when on the market, there is a clear trend after the long-term price consolidation in the horizontal diapason. On the chart, this situation is shown by a sharp outspread of the lines, after their long–term narrow position.
Generally speaking, Bollinger Bands contraction - or the appearance of a certain neck - is a fairly strong signal, which corresponds to the strong narrowing of the price change, and is easily seen on the chart. Such stiction signifies the abnormal position on the market, and will sooner or later be followed by the extensive move with a formation of a new rising or descending trend.
Bollinger Bands go well on every type of charts, from minute- to day-long ones. But making a decision about the position’s opening or closing, one should never reckon a single indicator. The verdict should always be supported by a few indicators. The more instruments, which are used for forecasting the price change on Forex, give the signal, the more reliable it is.
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