Volatility is an important concept in the forex markets. It is defined as the degree of variation in the price of a security measured over a period of time. This measure can be a standard deviation or logarithmic returns.
By building a simple, yet effective, Bollinger bands strategy, traders can profit on the forex markets.
The volatility shows how much or how far the price of a security can deviate from its historical average price. When volatility increases, the security becomes riskier to trade. However, as risk increases, the rewards increase as well.
Many technical indicators have been developed to measure volatility. Among these, the Bollinger bands indicator stands out, as it simultaneously measures volatility and trend. When traders combine volatility and trend, the market context should be clear.
John Bollinger developed the Bollinger Bands (BB) indicator in the 1980s, and the name has also been trademarked. The indicator is based on the concept of trading bands and visually stands out.
How do Bollinger Bands work
The Bollinger bands are comprised of three price bands. The mid-band is a 20-period simple moving average. The outer bands, also known as the upper and lower BB, are set two standard deviations away from the average price.
When price volatility rises or falls, the outer bands expand to indicate rising volatility or contract to indicate falling volatility. Rising volatility can indicate strong price trends. Falling volatility indicates sideways or consolidating markets.
For traders, the greatest difficulty is in understanding when to trade the trends. Certainly, it is not advisable to trade when volatility is low as markets can become choppy.
The Bollinger bands were developed to be used on the daily chart. However, traders can use this indicator across any time frame. For the most part, the default settings of 20, 2 are used, but these values can be changed.
Factors to consider when changing the BB values include the time frame used and the volatility of the security in question.
Understanding volatility with Bollinger bands
The Bollinger bands have the default setting of 20, 2, and this usually suffices for most currency pairs. Once the indicator is plotted on the price chart, there are different ways to trade the forex markets.
First, traders should know the Bollinger bands indicator shows rising and falling volatility. When volatility is rising, trends can be strong, and therefore, the risks are limited. Conversely, when volatility is low, markets tend to range.
Trading the sideways market is always risky, but it can also yield significant profit. In the end, it is up to the traders to decide what works best for them.
Below are two ways to understand volatility:
Trading volatility breakouts
Trading volatility breakouts is the easiest way to trade the Bollinger bands. In this approach, traders wait for the bands to contract. This signals sideways consolidation, which usually comes after a strong trend or precedes a breakout.
The breakout is usually signalled by the upper and lower bands expanding in opposite directions. Trends are the strongest at this point, and traders can book some quick profits. However, there is always a risk of a fake breakout, which traders should be aware of.
Trading the consolidation
One can also look to trading the consolidation phase. During this phase, the bands contract, indicating lower volatility. Traders can make use of additional indicators, such as oscillators, and trade the sideways range.
This approach is usually risky and requires considerable practice. It is very easy to lose money when the markets are trading flat.
When volatility is used in conjunction with the larger markets, you can expect to see strong trends emerge. Therefore, traders should not use the BB volatility in isolation but also look at the larger prevailing trends.
Bollinger bounce strategy
The Bollinger band bounce is one of the most common ways to trade with the indicator; other strategies include walking the bands as well.
The Bollinger bounce strategy is a simple concept. Traders look for a fake breakout, which is usually in the opposite direction. This concept tends to catch weak traders unaware as they enter the market a bit too soon.
With the orders trapped, price action then reverses direction and moves in the previous direction of the trend. Capturing the band bounce during this scenario can yield good profits.
Typically, during the Bollinger band bounce, you can expect volatility to fall. As a result, the bands tend to contract. This will prepare traders for a potential breakout trade in the making.
In this first example, we will illustrate the Bollinger bounce for buying. As the chart shows, we have the classic bounce pattern here. Price initially moves higher and then makes a pullback.
Following this, price then reverses direction. At this point, you can see a modest contraction in the bands. An important point here is that this period of low volatility appears only briefly. Therefore, traders must be ready to act when the pattern is formed.
After the bounce, price breaks out from the previous high. You can buy the forex pair on the first bullish close after the breakout.
When selling, we expect price to pull back before resuming its downward direction. The chart below illustrates this concept.
In the above example, price is in a downtrend. Following a brief spell of contraction, price makes a pullback in the opposite direction. Eventually, we see that price breaches the previous pivot low that was formed.
Sell positions can be placed on a bearish close below the previous low.
The Bollinger bands might look similar to the envelopes indicator. However, since BB also accounts for volatility that constantly changes to price, it is more “elastic”. It is a great tool for traders who are willing to trade the forex markets because one can anticipate the changes in volatility and trade accordingly.
The Bollinger bounce strategy is simple and easy to use. It takes a bit of practice, but eventually, traders can see success with this strategy, which can be applied to daily and weekly forex trading.