Changes in the price of an asset may be insignificant for a long time – for example, an average daily change of 0.05%. If a 1% change occurred one day, it would be a huge difference from normal. There would be increased volatility, and technical indicators would represent it graphically.

In investing, volatility is often seen as an indicator of risk. It can rise or fall. Higher risk poses dangers, but also offers opportunities. Increased volatility is probably triggered by certain information and is likely to set off a price movement.

The volatile market usually makes quick and larger than usual movements. These periods are rare but significant as a price impact. For example, in the stock market, the upward cycle lasts for years, but within months it can crash by as much as 50%. These are periods of pronounced momentum and increased volatility.

Various volatility indicators are available to help traders. One of the most popular is the Bollinger Bands ®.

Bollinger Band®

Bollinger Band® (BB) is an indicator built on price volatility. A channel with three lines is formed directly on the chart. The midline is a simple moving average (20 periods) and the end lines are the +/- 2 standard deviations of this average (settings are subject to change). As such, they will restrict prices within their boundaries for a huge part of the time.

When volatility rises, the standard deviation will increase – hence, the end lines will widen. It is possible that prices will leave the BB borders for a short time or for longer if a trend has started. Conversely, during periods of low volatility, the lines will be close to each other and prices will move within these boundaries. This behavior of the indicator can be clearly seen on the chart below.

Chart 1: Bollinger Bands. Chart: MetaTrader4

Chart 1: Bollinger Bands. Chart: MetaTrader4

BB should be interpreted according to the traditional rules of support and resistance. Prices above the middle line – bull market, prices below it – bear market. Accordingly, when reached, it will play a role of support or resistance.

The other two lines reflect 2 standard deviations of the average. Statistically, this means that prices will close very rarely outside the boundaries. So, these end lines will be a supportive or resistive factor of last resort. Overcoming them probably happens for a reason that is worth exploring. Strong trends usually involve a series of closing prices outside the BB borders.

Chart 2: Bollinger Bands Volatility Changes. Chart: MetaTrader4

Chart 2: Bollinger Bands Volatility Changes. Chart: MetaTrader4

It is believed that the longer the prices consolidate in a period of low volatility, the stronger the trend will be thereafter (Chart 2). The idea is that the currency pair has spent quite a bit of time in balance and the available market information has been consumed. When new significant information enters the market, a move is initiated.

As long as prices close outside the boundary (in the example, declining prices below the lower boundary), the trend is confirmed. First signals of uncertainty would occur when the pair closes inside the boundaries. When this happens, the average will become the next natural resistance.

These moments often provide traders with an opportunity to join the trend, increase/decrease volume and adjust stops. The eventual break of the average will put the downtrend into question. In uptrend the logic is the identical.

However, it is not always the closing price outside the boundaries that marks the beginning of a trend. It is a matter of comprehensive analysis how reliable each individual signal is. In many cases, a given day (or an optional period) may realize breakouts, but the next price enters back within the boundaries and calls into question the strength of the move.

Chart 3: Bollinger Bands Support/Resistance Lines. Chart: MetaTrader4

Chart 3: Bollinger Bands Support/Resistance Lines. Chart: MetaTrader4

The chart shows how on several occasions the price has closed outside the end boundaries, but the subsequent movement has been insignificant and has quickly reversed. In the latter case, the upward break set off a rise of several figures. Perhaps other indicators and TA methods will account for this moment. This is also a break of previous price top, which is additional confirmation from technical perspective.

From statistical perspective prices are expected to fluctuate within a distance of +/- 2 standard deviations for 95% of the time. So, one can easily expect to see prices returning inside the channel after an initial breakout of the boundaries. That in turn creates opportunities for mean-reverting strategies.

Distinguishing situations with potential is the main challenge. BB is an indicator of volatility. In this regard, it should be understood that it does not generate signals in the literal sense but complements the overall picture. It is best used in conjunction with momentum or volume indicators. If there is a synchrony between their signals, the trading opportunity probably has good prospects. 

Many traders exploit the idea of support and resistance based on volatility. It is common to add another 1-standard deviation line, which provides additional points to move stops and implement other position management techniques.

The BB offers an alternative view of the market environment. To this day, it continues to be among the most widely used volatility indicators.

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