An Intern Learns – Technical Indicators; Bollinger Bands
Today we are going to take a closer look at some of the handy tools available to traders to help predict trends. As I discussed in my previous blog, indicators are used to help discern the direction of the market. Today I want to expand on this by looking at how multiple moving averages can be used as well as looking at Bollinger Bands. At this very moment of writing I’ve got a trade going on – GBP/USD. I’ve placed an order based on my speculation that the GBP is going to strengthen. I’ve got my MA’s inserted and my Stop Loss and Take Profit limits. The chart is set on the 15-minute time frame and now it’s time to sit back and hold thumbs! I’m still quite unsure as to exactly what I’m doing; a lot of this is still in the experimentation phase for me! Luckily I’ll still using my demo account and in this way at least if I sustain a loss it won’t be with my own money.
So in my trade I used my moving averages to guide my trading decision. As you know, some of the most common moving indicators to use are the Simple Moving Average and the Exponential Moving Average. Just a quick recap; these are lines that cross through the charts, giving an indication of the trend. The SMA is calculated based on the period (time duration) that you use. The longer the period, the smoother and less up and down the line appears. The EMA is worked out in a similar way except that the EMA places greater priority to the more recent movements of the charts and so is quicker to react to market changes.
Now a clever trick to do is to use these in conjunction, or with different time periods. The time periods you use with your MA should reflect the trading style you choose. For example, if you are looking at making a small profit over an hour or two, and very long SMA period won’t give you the information you need. For example, a 60 period SMA adjusts the line with information over 60 days – 2 months! As you can see this amount of time won’t be relevant to a short term trading decision. On my demo account today I’ve decided to not try scalping, but rather let my trade ride for a day or two. I have also decided to use two SMA lines. This is a technique known as crossover trading and involves looking at the two trend lines and how they interact together to determine the trend of the market. Basically the way you would do this is to plot two different lines, in my case I’ve used a 7 and 14 period. As they cross over, this can indicate a change in trend. Typically when the higher number SMA is on the bottom and then crosses over the lower SMA to be on top, this will be in correlation with a change in market trend. If the lines move as I just described then the trend will typically move downwards. The opposite also applies to describe a change to an upward trend. By looking out for a crossover in your trend lines, this can act as a clue to a potential change in trend. In the picture below you can see that just after 5am there was a switch over of the MA lines and this coincided with a change in the price direction.
Another way to use MA’s are as dynamic support and resistance indicators. In the same way you would look at a chart and draw in straight lines to show the level of resistance or support, MA’s can be used as dynamic ones in the sense that they still move with the chart as opposed to being drawn on. To achieve this you would set the period quite high. This has the effect of making the line smooth out quite drastically. Where the bars ‘bounce’ off the trend line, this could indicate a level of resistance and support. However just like regular support and resistance levels, the price can still burst through so use with caution!
Now although it is all well and good to use these MA’s remember other tools that you have used before. You can also use EMA’s to help too, regular support and resistance levels, as well as using fundamental analysis, where you use the news to make a speculation on the charts. Remember trading involves risk and it’s therefore important to have as much knowledge as possible to make your decisions.
The last tool I want to discuss today are Bollinger Bands. These are also classed as technical indicators but are different to E/SMA’s. A Bollinger Band is used to indicate Market Volatility. The logic behind this is that when there is high volatility, there will be greater changes in price. This provides an excellent opportunity to scalp, or as an indicator of when to enter the market. In the picture below I’ve used the EUR/JPY pair (as they show more volatility than the GBP/USD pair I’m currently trading). As you can see, Bollinger Bands run above, through and below a chart, with the basic premise that where the outer bands tighten to the centre, this will be a precursor to higher volatility and big changes in trend. In the picture you can see that at 7:15 on Oct 1st the bands contracted and then suddenly expanded; this indicates great market volatility and as you can see the price spiked upwards. The trick here is to enter the market at these points to maximize your earnings.
I have mentioned before that less is more. In the case of technical indicators, using all of them at the same time won’t necessarily help. For example, in a market that is showing small variation in price, Bollinger bands may provide little insight. However if it is a historically unpredictable pair, such as the cross or exotic pairs, Bollinger bands may prove useful. Ultimately, the important thing is to know all your tools well, whether they be MA’s or Bollinger bands, and more importantly, knowing when to use them. You will never be able to predict the future, but indicators can provide insights that can help guide your decisions.