Bollinger Bands Explained

What are they? Bollinger Bands are a pair of trading bands representing an upper and lower trading range for a particular market price. A market price or currency pair is expected to trade within this upper and lower limit as each band or line represents the predictable range on either side of the moving average. The lines are plotted at standard deviation levels above and below the moving average. This trading band technique was introduced by John Bollinger in the 1980.

Why use them? Bollinger Bands can be very useful trading tools, particularly in determining when to enter and exit a market position. For example: entering a market position when the price is midway between the bands with no apparent trend, is not a good idea. Generally when a price touches one band, it switches direction and moves the whole way across to the price level on the opposing band. If a price breaks out of the trading bands, then generally the directional trend prevails and the bands will widen accordingly.

Key features of Bollinger Bands:
1.A move originating at one band tends to go all the way to the other band.
2.Sharp moves tend to happen when the bands contract and tighten towards the average,
when the price is less volatile. The longer the period of less volatility then the
higher the propensity for a breakout of the bands.
3.When there is a breakout of the band, then the current trend is usually maintained.
4.A top or a bottom outside the band that is followed by a top or a bottom inside the
band indicates a trend reversal

Configuration and Confirmations
The most commonly used and hence default bands are drawn 2 standard deviations away from a 20 period simple moving average. This is for intermediate-term analysis. However, the number of periods and standard deviations can be varied. John Bollinger himself states "Choose one that provides support to the correction of the first move up off a bottom. If the average is penetrated by the correction, then the average is too short. If, in turn, the correction falls short of the average, then the average is too long. An average that is correctly chosen will provide support far more often than it is broken."
The Chart below is a 4-hour chart depicting the EUR/USD pairing. You can see that while the price generally remains within the band, there are a number of breakouts, particularly when the bands are in a narrow range. Some breakout trends are not sustained and the price action is quickly restored to within the band range. If the breakout does represent a real market shift then a continuation of this trend is generally upheld and the Bollinger bands automatically widen to accommodate this.
Bollinger Bands should be used as a measure together with other measures, most notably the Average Directional Index (ADX), RSI and Stochastic indicators.




The 15 Rules of Bollinger Bands
1.Bollinger Bands provide a relative definition of high and low.
2.That relative definition can be used to compare price action and indicator to
arrive at rigorous buy and sell decisions.
3.Appropriate indicators can be derived from momentum, volume, sentiment, open
interest, inter-market data, etc.
4.Volatility and trend have already been deployed in the construction of Bollinger
Bands, so their use for confirmation of price action is not recommended.
5.The indicators used for confirmation should not be directly related to one another.
Two indicators from the same category do not increase confirmation. Avoid
colinearity.
6.Bollinger Bands can also be used to clarify pure price patterns such as M-type;
tops and W-type bottoms, momentum shifts, etc.
7.Rice can, and does, walk up the upper Bollinger Band and down the lower Bollinger
Band.
8.Closes outside the Bollinger Bands can be continuation signals, not reversal
signals--as is demonstrated by the use of Bollinger Bands in some very successful
volatility-breakout systems.
9.The default parameters of 20 periods for the moving average and standard deviation
calculations, and two standard deviations for the bandwidth are just that,
defaults. The actual parameters needed for any given market/task may be different.
10.The average deployed should not be the best one for crossovers. Rather, it should
be descriptive of the intermediate-term trend.
11.If the average is lengthened the number of standard deviations needs to be
increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if
the average is shortened the number of standard deviations should be reduced; from
2 at 20 periods, to 1.9 at 10 periods.
12.Bollinger Bands are based upon a simple moving average. This is because a simple
moving average is used in the standard deviation calculation and we wish to be
logically consistent.
13.Be careful about making statistical assumptions based on the use of the Standard
deviation calculation in the construction of the bands. The sample size in most
deployments of Bollinger Bands is too small for statistical significance and the
distributions involved are rarely normal.
14.Indicators can be normalized with %b, eliminating fixed thresholds in the process.
15.Finally, tags of the bands are just that, tags not signals. A tag of the Upper
Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger
Band is NOT in-and-of-itself a buy signal.

Euro reaches all-time high against Japanese yen

LONDON (AFX) - The euro forged ahead to reach a new all-time high against the Japanese yen this morning, touching the 158 yen level, where large offers put a halt to its progression.

Economists said the yen has been failing to enjoy any support from expectations that the Bank of Japan will deliver a rate hike this year, as traders seem to believe borrowing costs are not destined to rise much more after that.

'Prospects for low long-term rates in Japan remains a compelling argument for yen outflows,' said Russell Bloom at IFR Markets.

'European traders have been keen to exploit this theme early on in the year.'

The morning rally was helped by a larger-than-expected fall in German unemployment. German adjusted unemployment fell by 108,000 in December, against expectations for a 45,000 decrease, and supporting views that European rates will be heading higher.

'The European Central Bank (other-otc: CHPA.PK - news - people ) remains on course to hike the refi rate at least twice more in the first half of 2007, taking it to 4.0 pct from its current 3.5 pct,' said Stuart Bennett at Calyon, adding that it supports a strategy for more euro gains against the dollar, targeting 1.3560.

The dollar, however, has remained well-bid against the euro this morning, with economists attributing the move to trading flows and profit-taking ahead of a string of key US data today.

The ISM manufacturing index, the ADP employment index, vehicle sales, construction spending and the minutes from the Federal Reserve's last policy meeting are all due today.

'There is some room for surprises from the Fed minutes,' which has continued to cite upside risks to inflation despite a slowing economy, said Simon Derrick at Bank of New York (nyse: BK - news - people ).

Overall, however, the dollar is bound to be outshone by the euro and the pound, analysts said.

'Once we find ourselves in more normal trading conditions, maybe towards the end of the week, the euro will continue to share centre stage with the pound,' Derrick said.

The pound remained supported by economic data which has surprised to the upside over the past month, fuelling views that the Bank of England may raise rates at its February meeting.

Although it gained ground against the yen, the markets nevertheless saw some profit-taking against the dollar, bringing the pair down from the 1.9700 level towards 1.9666.

Portfolio Hedging With Forex

All too often, investors get caught up with how much they hope to make in their portfolios and they forget about keeping what they already have. Your first priority, as an investor, should always be to protect your principal. Once you’ve taken care of that, you can start focusing on making that money work for you. The currency market offers tremendous protection for your other investments.

A hedge is a series of bushes or small trees that have been planted in a row to distinguish one plot of land from another. Medieval English landowners and privacy-starved celebrities are famous for their hedges. The landowners planted hedges because they wanted to define boundaries and create limits to protect their land. Celebrities plant hedges to provide a barrier between themselves and the paparazzi. But these two groups of people aren’t the only ones who create hedges. In fact, everybody does it.

Hedging--or protecting--your property or privacy is a natural instinct. We deposit our money in a bank to keep it safe. We keep our valuables in a safe or a safety deposit box to ensure that nothing bad happens to them. We lock our doors and install security systems to protect us from anything that may be dangerous. We put up fences around our yards. We put passwords on our computers. Basically, we protect everything we own.

Everything, that is, except the value of our money. We protect the money itself by placing it in banks, safety deposit boxes and the like, but we rarely protect its value. The value of our money is exposed to at least one of two financial risks: market risk and inflation risk.

Market risk is the risk you accept when you put your money in the market, be it stocks or bonds. If the market crashes, the value of your investments will also crash. True, the broker handling your investments may be a strong company with impeccable standards, but the fiscal and ethical prowess of your broker has very little to do with the safety of your investments. Regardless of the strength of the firm you invest through, you are still exposed to market risk.

Foreign exchange (or Forex) investing is the solution to market risk because you can offset your losses in the stock or bond market with your gains in the Forex market. You can place trades in the Forex market that will profit from the decline in the stock or bond market. By doing this, as your balance in your stock or bond account declines, the balance in your Forex account is increasing. When you look at your overall portfolio using this strategy, you will notice you have not lost any money. You hedged against the losses resulting from market risk by investing in a different market, Forex.

“I’ve taken care of market risk,” you may say. “I’ve put my money in CDs, money market accounts and bonds. No matter what happens, I will never lose my principal.” While this may be true, you have still accounted for only one of the two financial risks. You may never lose your principal, but conservative investments do not protect you from inflation.

Inflation risk is a risk you have to accept. You cannot escape it. Inflation decreases the purchasing power of money. This means that as inflation continues, you will be able to buy less and less for $1, and your savings and investments will lose their value. The price of U.S. postage stamps provides a great illustration of the effects of inflation. In 1960, the price of a stamp was less than 5 cents. Today, the price of a stamp is 39 cents. That is an increase of nearly 700%. Obviously, $1 bought a lot more in 1960 than $1 buys today, and that trend is only going to continue. If inflation rises at a higher percentage than the percentage of return you are receiving from your conservative investments, you are actually losing purchasing power even though you are making money.

The Forex is the solution to inflation risk because you can offset your loss of spending power with your gains in the Forex market. Inflation affects the Forex market in a fairly predictable manner. Knowing this, you can make your Forex trades accordingly and profit from rising inflation. You can then take these profits, combine them with the profits from your other conservative investments, and nullify the effects of inflation.

Remember, you need to protect the money you have before you go out and try to make more money. But once you’ve mastered how to hedge your portfolio, you should definitely look to the currency market to boost your returns. In fact, you can take advantage of a lot of the negative things in your life and turn them into money-making opportunities.

Forex - US dollar slightly firmer vs yen in late Sydney trade

MANILA (XFN-ASIA) - The US dollar was slightly higher vs the yen in late trade here, though in light volumes because of holidays in key financial centers, dealers said.

They said the greenback is likely to continue moving in a narrow range until fresh leads emerge from the US and Europe.

At 4.45 pm (0545 GMT) the dollar was at 118.75 usd from 118.70 in early afternoon trade here while the euro was at 1.3234 usd from 1.3240.

'There has been no catalyst, no data and everyone is still coming off holidays so there hasn't been much to move markets,' State Street Global Markets head of research and analysis Harvinder Kalirai said.

Kalirai said tonight's release of the Institute of Supply Management's December US manufacturing survey is the next potential market mover but trading will continue to be affected by US financial markets being closed in honor of former President Gerald Ford (nyse: F - news - people ) who died last week.

A Volatile Week to Come

After a month of consolidation, much volatility is expected for the first week of 2007 on the back of a economic release scheduled with important indicators every day. The US calendar will start will ISM manufacturing index on Tuesday. This manufacturing index has dropped for the fourth consecutive month in Nov and reached a sub-50 contraction level of 49.5 for the first time since 2003. A rebound is expected by economists to push this index back to expansionary level 50 and end the losing streak. Tuesday will also be a manufacturing day featuring Manufacturing PMI indices from Germany, Eurozone and UK.

The highly anticipated release of Fed Minutes was rescheduled to Wednesday. Focus will be, again, on Fed's view on growth and inflation, in particular, after further indication of slow down in housing and manufacturing industries and tamed inflation data. Markets are expecting the Fed to hold steady in first quarter but such expectation could easily flip to rate cut in case of a dovish minutes from the Fed.

ISM non-manufacturing index will be featured on Thursday, which is expected to retreat mildly to 57.0 after scoring a surprise 58.9 in Nov. Such reading, together with a rebound in the manufacturing index, will suggest that those the pace of the economy in US has slowed, it's still steady and will reduce the odd that Fed will cut rate soon. Thursday will also feature services PMI indices from Germany, Eurozone and UK. Plus Canadian PPI.

Non-Farm payroll will be featured on Friday. Consensus call for a mild drop in job growth to 115k in Dec, with unemployment rate remains at 4.5%. Again, focus will also be in revisions to prior data as well as other indicators including wages. Also, Eurozone PPI and retail sales will be released.

In short, we'll be having a busy week with highly market moving economic releases every day. Prepare for a roller coaster ride!

Wish our readers a prosperous and profitable 2007!