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Abe’s Trading Tip: 2 are better than 1
By Mike Conlon | July 28, 2010
Here is a simple trading tip that is provided by our guest contributor and professional trader Abe Cofnas
Among technical indicators, Bollinger Bands is one of the most famous as well as useful. Basically, a Bollinger Band is a statistical bell curve. Each band represents a standard deviation distance from a moving average. The standard setting is 20 for the simple moving average, and 2 for the standard deviation. If you don’t remember basic statistics, one standard deviation would mean that the price is 67% of the time between the two bands, and 2 standard deviations means that the price is about 96% of the time between the two bands. We should add that 14 represents the default periods.
Now that we got a basic definition out of the way, I want to point out some better understanding of the use for the bands for currency pairs. First, many traders misinterpret the fact that a price is probing one of the bands. They see this situation as a reversal indicator. It is not! Just because a price goes to a Bollinger Band doesn’t mean it is going to reverse. Remember, it got there for a reason. Sentiment has pushed the price to the outer levels of the band. All it means is that there is an alert to watch out. It may reverse. A second point is important, the shape of the band itself. If the Bollinger Bands are sloped up or down, its more likely than not that if a price goes to the band, it will stick along there. A sloped band reduces a bounce potential. Very often we see a price stay for a long time hugging an upward slope, or sliding down a Bollinger band- but not reversing. We can see this in the example below. The candles went beyond the lower band, and stayed below for a while before it reversed up. The slope of the Bollinger Band was not level. But when the price went to the upper band and actually penetrated it, notice the band was very flat. A reversal then occurred.
A good idea when using Bollinger Bands is to add another band with a different setting. I call this an Extended or Extreme Bollinger Band. The second Bollinger Band provides a greater level of granularity to the price action. The question that the trader faces, is how extreme is the price when it hits the band. We saw with one Bollinger Band at a standard setting, a price probing the band is not a very reliable indicator on its own of a reversal. But when we add another band with a setting of (13, 2.618) things get interesting.
This setting shortens the moving average to 13 instead of 20, and extends the standard deviation to nearly 99% instead of 96%. In other words, if a price is at an Extended Bollinger Band, it is really extreme and more likely to be a reversal indicator!
Let’s look at the chart below with two Bollinger Bands. The outer band has the setting of (13, 2.618) and the inner band has the regular setting of (20,2). A nearly perfect “bounce” set up is seen in the middle. The Bollinger bands are flat. The candle went above the first band and touched the outer extended band and then came off it. A sell signal occurs when the price goes back below the standard band. The same scenario applies to a buy signal. We can see the candle went beyond the lower standard band, didn’t quite make the outer band, and returned back. It then moved back up for a nice bounce. The main point is that once we have a second extended Bollinger Band on, we can judge reversal conditions much easier!
Tags: Bollinger Bands, Breakout, currency trading, Forex, Moving Average
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