Volatility is the single factor that can have you netting hundreds of pips due to some Central bank statement, or that can have you pulling your hair out while your stop loss is triggered within seconds. Volatility is the difference between making tens of pips within minutes and having your trading funds tied down in trades that don’t want to go anywhere.
Trading the FX markets can be summed up in two concepts: trade in the direction of volatility, and respect supports and resistance.
I recently read about the Turtles, the “great Richard Dennis experiment”; and it was interesting to note that one of the reasons for their success was knowing “when to trade”. The forex market is a 24-hour, weekday market, so the general impression is that the market is always “moving” during those times. It is expected that such a large market with high liquidity should always give trading opportunities with large price movements. The reverse is the case. The markets actually trend 30% of the time (according to some book I read), while at other times it is in consolidation. This means our chances of getting large price movements are as high as we initially thought.
A volatile market can be very rewarding when you are trading in the right direction. Some traders use volume analysis to determine their entries, this is because higher volume naturally means more market players and a higher chance of price volatility. The drawback with watching for volatility is the fact that a trader has to wait till the “move” has started before jumping aboard.
“Remember it is quite possible to make large sums trading/investing if we are right only 30% of the time, as long as our losses are small and our profits are large.”
Bollinger bands is a technical analysis tool consisting of a moving average, an upper and lower band. This indicator is one of the best ways to gauge price volatility. Bollinger bands give a very clear picture showing the presence or absence of price volatility. There are several approaches that can be used when trading with Bollinger bands. For example, in a ranging or consolidating market, the upper band acts as a resistance area, while the lower band acts as support. In such situations, price is “squeezed” or contained between the upper and lower bands.
Above we can see how the bollinger bands effectively define resistance and support levels.
In the picture above, we see a perfect example of a break out; price breaks oit of the lower bollinger band and also breaks through support. This is an obvious increase of volatility and price is bearish.
I know of some traders who complain about ranging markets. I love ranging markets because I know that due to the high amount of liquidity in the currency markets, it is just a matter of time before price chooses a direction and breaks out of either the upper (Bullish) or lower(bearish) band. When this break-out occurs, after a ranging period, the chances of price action continuing in the direction of the break-out is very high. The general idea is to look for trades with a high degree of success. What we watch out for are contractions of the bands during ranging periods, and the break out of price from either the upper or lower bands.Below are some examples of contracting Bollinger Bands.
Contracting Bollinger Bands show periods of low volatility, with an indication of a pending break out.
The middle line (moving average) is also a very useful tool, which gives us an idea of the trend. If the moving average is pointing upwards (bullish), pointing downwards (bearish) and flat (ranging conditions).
We can see the Bollinger bands reacting very aggressively to increased volatility on the GBP/USD chart.
The trick is to identify ranging periods and trade the subsequent break outs.
Ideal entries are triggered by price breaking either the upper or lower band. We watch for a full candle opened and closed either above the upper band, for a bullish entry, and below the lower band for a bearish entry. Using bollinger bands require a fair amount of patience and a quick reaction to price.
Pending orders like Buy Stops can be placed above the upper band, and Sell Stops placed below the lower band; to activate our intended trades.
Bollinger bands have been around for quite a while, and is considered one of the best volatility indicators a trader can have in his or her tool kit. Trading using Bollinger Bands is a technical approach, and combined with price breaching resistance or support levels can be a very profitable strategy. If for nothing more, the Bands will keep you out of the market when there isn't much "action".
I hope this article has been informative and helpful. Please remember that trading the currency markets is not for everyone, so if you must do it, trade right and responsibly.