Standard Deviation, as described above, is a statistical measure of volatility. Standard deviation will be higher when prices are changing dramatically and lower when markets are calmer. In comparison to to the Moving Average Envelope indicator which keeps a static percentage band, the Bollinger Bands self adjust by widening and shrinking depending on volatility.
- When volatility is high the Bands widen.
- When volatility is low the Bands shrink.
Volatility is usually higher during reversals such as tops and bottoms. During a market top traders are either euphoric, and taking profits, or are in a state of fear that their short positions are doing so poorly.
Figure 2 – Examples of widening and narrowing Bollinger Bands. The daily chart is compressed to show the last year’s worth of price action for the Euro-Yen pair.
In the figure above, the green ellipses show periods of low volatility. The Bollinger Bands narrowed as a result. The larger red ellipse, corresponding to the first three months of this year, shows a trading range with high volatility and wider bands.
One can also see some market tops that are followed by quite steep drops, in the beginning of June, mid August, and especially in December. For the EUR/JPY pair during this time, market bottoms are not followed by such volatile swings. The start of the upswings are more measured and spread out through several trading sessions. The Euro is being accumulated during 2006 in comparison to the Yen, and there is more selling during a market top as those in long positions do not want to miss their chance to take profits when the currency pair starts falling. One must keep in mind that in Forex trading, a market top for the first currency in the pair, the Euro here, is a market bottom for the second currency in the pair, the Yen.
