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Is there such a thing as a 0 line based oscillator on charted in the price channel? Yes there is! They are called Bollinger Bands and were developed by John Bollinger. Bollinger Bands are a way to display volatility and relative overbought and oversold price levels over a specific period. Displayed as three bands and charted on top of the price channel, the bands surround or “envelope” the majority of a currency pair’s price action.
The three parts are commonly labeled as a centerline, upper band and lower band. The center line is usually a simple moving average, while the upper and lower bands are simply the centerline with a standard deviation added or subtracted.
What in the world is a standard deviation? Well, it’s a way to measure prices volatility. If you are really interested in knowing how the standard deviation is calculated, John Bollinger discusses this on his web site. For those that would rather move on, by using the standard deviation the bands react quickly to price movements to reflect times of extreme volatility in either direction. Because of the way the standard deviation is calculated, volatility or lack or volatility, in price action, makes the upper and lower bands widen or contract.
The standard settings for the Bollinger Band are a 20-day simple moving average for the center, with a 2 standard deviation set for the outer bands. Because there are many differing thoughts on the best settings, the moving average and deviation settings can be changed to fit different currency pairs.
It’s important to remember that back testing with different currency pairs with different BB settings will always produce the best results. However, there are a few rules that you should adhere to. First, the Bollinger Bands should envelope almost all price action, but should allow significant price changes to close outside the bands, with pierces the bands happening once in a while. There is no best setting, but when developed the (20, 2) setting were used by John Bollinger, and will work for most currencies.
Use these guidelines from the bbforex.com website for more direction when actually using the BB to trade.
1. Bollinger Bands provide a relative definition of high and low.
2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.
4. Volatility and trend have already been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended.
5. The indicators used for confirmation should not be directly related to one another. Two indicators from the same category do not increase confirmation. Avoid co-linearity.
6. Bollinger Bands can also be used to clarify pure price patterns such as M-type; tops and W-type bottoms, momentum shifts, etc.
7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.
8. Closes outside the Bollinger Bands can be continuation signals, not reversal signals--as is demonstrated by the use of Bollinger Bands in some very successful volatility-breakout systems.
9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the bandwidth are just that, defaults. The actual parameters needed for any given market/task may be different.
10. The average deployed should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.
11. If the average is lengthened the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.
12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent.
13. Be careful about making statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is too small for statistical significance and the distributions involved are rarely normal.
14. Indicators can be normalized with %b, eliminating fixed thresholds in the process.
15. Finally, tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.
Let’s let the above guidelines show us the way when going over the following charts.
You can see from the previous example that the rules are important. So how can we use the BB to trade effectively? Let’s take a look at a few ways to deploy the BB.
In the following example, we have a BB coinciding with a double top, double bottom and finally a break out to the top side with a price bar closing outside of the upper BB.
In the next example, I have used a second indicator that is often used to determine trends. As the purple line (ADX) broke above the –DMI line price closed above the upper BB. As price settled and the ADX fell lower trading between the BB would have produced 6 profitable trades with one loss as price again closed outside of the BB, only this time the lower one and continued lower as ADX again rose.
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