Another very important indicator, although not a stochastic one, is called Bollinger Bands.
Named for their inventor, technical analyst John Bollinger who invented them in 1982, Bollinger bands are indicators of volatility – rapid movement that is often a prelude to trend change.
Bollinger Bands are placed on top of a given price chart. They consist of a moving average based on the price, along with upper and lower ‘bands’ that define pricing "channels."
As always, you will not be obliged to make these calculations, as your forex platform will place the Bollinger bands on the chart for you. But you should understand how they work.
As you know, working with moving averages is a basic concept in technical analysis by forex traders. Bollinger introduced the idea of using standard deviation along with moving averages.
Standard deviation measures the amount of variability or dispersion around an average. Standard deviation is also a measure of volatility. Generally speaking, dispersion is the difference between the actual value and the average value.
By definition, one standard deviation includes about 68% of all data points from the average in what is referred to as a normal distribution pattern, while two standard deviations include about 95% of all data points.
Bollinger Bands consist of a middle band with two outer bands. The middle band is a simple moving average that is usually set at 20 periods.
A simple moving average is used because the standard deviation formula also uses a simple moving average. The look-back period for the standard deviation is the same as for the simple moving average.
The outer bands are usually set 2 standard deviations above and below the middle band.
The Bollinger Bands show the dispersal of rates when compared to the moving average, thus creating buy and sell channels. The area between the moving average line and each band produces a range, or channel.
The area above the moving average is referred to as the buy channel as spot rates displayed in this region remain higher than the moving average and suggest upward momentum.
The sell channel is created by spot rates falling below the moving average. As the spot rate is declining more rapidly than the moving average, it suggests that the exchange rate has downward momentum.
Moves above or below the bands are not signals per se. As Bollinger puts it, moves that touch or exceed the bands are not signals, but rather "tags".
On the face of it, a move to the upper band shows strength, while a sharp move to the lower band shows weakness. Momentum oscillators work much the same way.
Overbought is not necessarily bullish. It takes strength to reach overbought levels and overbought conditions can extend in a strong uptrend. Similarly, prices can "walk the band" with numerous touches during a strong uptrend.
It’s important to learn to use Bollinger Bands in combination with pattern observation and other indicators. Used in this way, they are a powerful aid to trading.