Bollinger Bands, like the Moving average envelope, try to identify periods when a currency is overextended. The guidelines below are quite general as there are many other aspects to consider when applying the Bollinger Bands to a sideways trend. It is very important to consider the characteristics of the ranging market; and any indications that a break out may be upcoming. During a trending market these techniques do not hold.
- If the price touches the upper band it can be considered overextended on the upside or overbought.
- On the other hand, if price touches the lower band the currency can be considered overextended on the bottom end or oversold.
One of the most useful features of Bollinger Bands is to use the above overbought/oversold guidelines to establish price targets during a ranging market.
- If price has bounced off the bottom band and crossed the centerline moving average then the upper band can become a sell price level.
- If price bounces down off an upper band and crosses the center moving average; the lower band can be used as a buy price level.
Figure 6 – Oversold and overbought conditions can act as price targets.
In Figure 6, of the USD/CAD pair, the ovals labeled 1, 3, and 5 are instances when the bottom bands can be used as profit targets during a short position. The instances when the price level hits the upper band as in 2, 4, and 6, the bands can be used as profit targets for long positions.
As an aside, the yellow oval in FIgure 6 shows an interesting dynamic. A trader that was mechanically following the above rules might have closed out his short position earlier then necessary (upon seeing a blue candle forming after the price touched the lower band). It is evident that the short bullish momentum was overcome by bears as the high of the day was quickly brought down. The support line (1.1450) holding the pair in a range buckled. The pair drops a hundred or so extra pips before heading back up.
