When you see your stock or forex prices are deviating from their norm, you have reason to believe they will soon return to it once again. This is the way price patterns work. After a pronounced trend in whatever direction, prices tend to consolidate. The new norm might differ from the old one, but prices won’t completely ignore it in negotiating fresh conditions. Progress is generally made in increments, not sudden rushes.
Anyone who uses Bollinger Bands in their online trading to detect oversold or overbought conditions is really relying on this principle. This is because Bollinger Bands are designed to help you recognize when prices are moving beyond their mean or average. Once you recognize this has happened, the benefit is in being prepared to brace yourself for that corrective push back towards the mean.
How do you recognize from the Bollinger Bands on your charts that your asset is either oversold or overbought? And what else can Bollinger Bands be used for? Get comfortable with the iFOREX team for a few minutes and we’ll give you the lowdown.
What are Bollinger Bands?
When you plot Bollinger Bands on your price chart, you’ll find you have a central line, called the SMA (simple moving average) sandwiched between an upper and lower band that seem to mirror its movements. The SMA data points are arrived at by averaging out closing prices for the asset over the last 20 days. Therefore, when you compare your actual price at a given point with the SMA, you’re seeing how much it differs with its average level for the past 20 days. The bands above and below the SMA are called standard deviations and they measure the average deviation of prices in both the upward and downward directions within that time period.
Tagging your Bands
Now that your erratic-looking price chart is safely held within the Bollinger Bands, some things become clearer. The first of these things is the general trend of prices – embodied in the SMA – over the timeframe of your chart, which is now freed from obscurity among the smaller price vibrations. But let’s focus on your prices and, specifically, how they are interacting with the upper and lower bands. In the event prices are hugging – called tagging – the upper band, your asset might be overbought and due for a fall. Vice versa, when prices hug the lower band, your asset could be oversold and have some upside on the way. And the basis to believe this is what we said before: Prices that wander far from their normal range will sooner or later find their way home.
The Squeeze
Let’s try to use your Bollinger Bands for something else: Find a point where they converge, or squeeze, close together. It’s likely you’ll notice that prices are consolidating around that area because squeezed bands indicate stability in prices. When prices go sideways like this, we’re immediately on the look out for a large movement in either direction because this is inevitable. Thus it is that squeezed bands indicate potential volatility ahead.
The problem is that you don’t know which way that volatility is going to jump, or when it’s going to jump, and Mr. Bollinger, unfortunately, cannot help you on either score. The only job he knows how to do is to herald the onset of action. If you want to know about timing and direction, call up Mr. MACD (moving average convergence divergence) indicator or Mr. RSI (relative strength indicator). They’ll be happy to oblige. And, by the way, the opposite is also true: When the Bollinger Bands are far apart, we know volatility is high and this, we know, cannot go on forever. Our reaction, then, is to anticipate a return to stable conditions.
Summing Up, Signing Off
A couple of important points to finish off with: It should be clear from all the above that, when prices tag the upper or lower Bollinger Bands, this does not constitute a buy or sell signal. Don’t make the mistake of thinking that it does, as many people tend to. What tagging shows is just that conditions are tending towards being either oversold or overbought.
When you use Bollinger Bands during strong price trends, remember the following things: Only act on an overbought signal if the present trend is a downtrend. Only act on an oversold signal if the present trend is an uptrend. In other words, don’t just take the message from the Bollinger Bands and run with it if you would be going against the actual price trend right now.
When you trade CFDs in the price movements of stocks, commodities, or forex pairs on the iFOREX trading platform, you enjoy the client support of one of the most established companies in the business. You’ll also get access to iFOREX’s super-useful education centre, which goes a long way in keeping your trading head on the ball.
