Bollinger bands are both a volatility indicator and a tool used by forex traders to generate trading signals. When the upper and the lower bands are close to each other, the volatility of the currency pair is low and so is the trading volume. This is the case where the pair is said to be “consolidating”. Otherwise, it is “trending”. The former situation is called “squeeze” of the Bollinger bands, because they are restricted tightly together. When this situation occurs, traders usually prefer to stay out of the market, because consolidating pairs is significantly less profitable than trending ones.
The empirical evidence and the trading experience show that currency pairs typically swing from periods of low to period high volatility. The “squeeze breakout” is a reliable signal to enter the market, when the price goes beyond one of the two bands. This suggests that the range bound market is coming to an end and it is likely the pair is entering into a new trend phase.
When price touches the lower band is a standard signal which indicates that the pair is oversold, as measured by volatility. As a result, a bullish bounce could occur. If the price starts falling quickly at the lower band instead, and the distance between the two bands widens, then entering a long trade is not a good choice. When the bands are expanding and a strong price momentum below the lower band is observed, this hints that a bearish bias still persist.
The same happens when price touches the upper band, which acts as a hidden resistance level based on an extreme volatility level. However, if the upper and the lower bands expand and the price starts above the upper one, then a bullish expansion is the best thing to expect.
The breakout in the Bollinger Bands 20-period Simple Moving Average (SMA20) is considered a confirmation signal, which usually comes after the price interacted with the bands. If the price bounces from the upper band and then breaks the SMA20 downwards, this can be interpreted as a strong short signal. If it bounces from the lower band and breaks the SMA20 upwards, it can be interpreted as a strong long signal. These are two expamples which helps to understand why the SMA20 breakout can be used to set trade points.