How to use Bollinger Bands when trading the markets

EXPLOSIVE moves: everyone wants to be part of them, but how can we detect them before it’s too late? A basic indicator which is standard on most systems are Bollinger Bands. Loading this indicator for a FX pair like euro-dollar will show you the 20 day moving-average and the standard deviation of price over the same period. The standard deviation will be shown as two lines, one above and one below the current 20 day range.

An explosive move will usually take off when prices on the daily chart close above the upper or the lower standard deviation line. I know this because I back-tested it on euro-dollar and detected over 100 signals using the daily time frame.

The logic of Bollinger Bands is that they will expand as volatility increases, and contract when volatility is dying out. In other words, an explosive move is underway when we push against one of the bands.

In the case of euro-dollar, we tend to get a rally which extends for 18 days on average. Settings used are 20 days and two standard deviations. To help validate a signal, it’s always good to trade with the general macro-fundamental trend.

This technique works well with FX pairs that trend, like euro-dollar, Aussie-dollar and dollar-yen, but does not really work for stock market indices. This is because it is not usually profitable to buy stock markets as they trade above a major high. FX markets, on the other hand, have very strong trends, and it makes sense to go with the flow.

By Alejandro Zambrano is a currency strategy analyst at DailyFX.com.