5) MA envelop – Bollinger Band:
If you consider the moving average as the mean price action of a certain period, then that means a range-bound market should revert back toward it. Thus the farther price is away from the MA, the more more likely it wants to “regress to the mean”.
The bollinger band is designed to measure where the market might be too far from the moving average.
Traditionally the bollinger band plots the 20-day moving average and a band 2 standard deviations above and 2 std deviations below. The parameter was used with consideration for stocks and the fact there is about 20 trading days in a month.
Here is the calculation of a bollinger band using 20-day SMA and 2 standard deviations to calculate the upper and lower bands, provided by ChartSchool.com
Middle Band = 20-day simple moving average (SMA)
Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
Statistics tells us that 2 standard deviations is suppose to contain about 95% of values within a normal distribution (or one that fits the bell curve). This distribution model can be used for height, weight, IQ, among other things we consider. The distribution of price action is not necessarily such, so there is a conceptual leap here using the statistical theory, and thus draws criticism to the bollinger bands effectiveness in predicting overbought/oversold reversals.
Instead of the normal distribution, consider the Fat-tail distribution.
However, this does not mean the Bollinger band is useless, it just shouldn’t be used as a single indicator to go against a trend. The bollinger bands overbought/oversold signals are like any oscillator’s in that they work during sideways or range-bound markets.
I personally use 200SMA instead of 20, and put 3 standard deviations to catch markets that would be significantly more extreme (far from the MA), than would be shown by the conventional parameters.
Here is an example of the USD/JPY market exhausting in the 1H chart after showing overbought conditions and then returning back to the 200SMA. Note additional clues of exhaustion from a bearish divergence with the RSI.
It should be noted that when the market is overbought/oversold, there is a likelihood that the market still consolidate. Sometimes that develops as a “regression” back toward the 200 moving average, sometimes it consolidates sideways until the some of the moving averages catch up before continuing the trend.
Here is an example where we stalled at the lower bollinger band, with the similar signals shown in the above example. However the EUR/GBP continued the down trend after the correction returned to the 100-day, NOT 200-day SMA:
In construction of other indicators:
Fan Yang CMT is the Chief Technical Strategist FXTimes – provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.
Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.