The Bollinger Bands is one of the most famous technical tool used by forex traders. They belong to the on-chart volatility indicators, as they have been created to capture market volatility. Graphically, they are made of an upper and a lower band, whose trend depend on changes in market volatility. The Bollinger bands look like a channel which captures the price action at the upper and the lower extremes.
The rule on which they are based is the following. The higher the volatility of a currency pair, the further the distance between the two bands. The lower the volatility, the nearer the distance. In the typical technical analysis packages, the Bollinger bands are based on a standard 20-period Simple Moving Average (SMA), which is a useful average to choose the right entry and exit points of trades.
As we said, the Bollinger Bands are made of three bands: the upper, the lower and the middle. The middle one represents a 20-period SMA, calculated by summing the closing prices of a currency pair for the last 20 observations and then dividing by 20.
Also the upper and lower lines are calculated exploiting a 20-period SMA of the price and its standard deviation. Usually, the default standard deviation used by packages is equal to 2. In the technical analysis literature, the Bollinger Band are written in the following fashion: (SMA = 20, sd = 2).
Notwithstanding the Bollinger Bands are a volatility indicator, they are often used by forex traders to detect support and resistance levels. Each of the three lines could be used to identify supports and resistances. When the bands are used for this goal, a trader should always remember that the upper and lower bands usually provide better results, in terms of accuracy, than the middle line.