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The market enjoys two basic trading conditions which tend to repeat on a very regular basis; range bound and trending states. As buyers and sellers establish the extreme overbought and oversold regions, these two opposing forces begin to approach one another, and a trading range develops as relative support and resistance levels begin to approach one another. This phenomenon often times takes the shape of a triangle consolidation pattern. Eventually either the buying or selling side takes control, forcing the opposition into submission as a new trend develops and as the market trades at new highs or lows. Once this trend exhausts itself and the market fails to accomplish new highs or lows, a new range will now develop.
As the market continues to cycle between trending and ranging conditions the Bollinger Bands will continue to expand and contract based on its relative states of volatility. During trending markets the Bollinger Band Width indicator tends to rise as the bands that it measures expand away from each other. On the same note, when a range bound condition ensues the Bollinger Band Width line tends to fall as the bands contract once again towards one another. Although there may not be a notional value to gauge low or high extremes of the Bollinger Band Width line, we can approximate the ultimate high and low points by simply noting recent trading activity on the chart. More importantly we should note the direction of the Width line, as it falls after visiting extreme highs, or rises after touching extreme lows.
Now the question remains, how can we use this in our day to day trading operations? Very simply, we can see the following 2-hour chart, the GBP/USD has formed and subsequently broken out of a number of triangle patterns as the Bollinger Band Width line rises and falls respectively. As a triangle develops, we may choose to go long near support and sell short near resistance, and we may continue to do so profitably until the Width line falls to an extreme low, and then reverses to the upside.
On the same note, in a trending market, we may choose to buy new highs, or sell new lows until the Width line touches an extreme high, and then reverses to the downside. Although the notional value of the Width line is important to note, the current direction of this line may be more helpful in showing us the future implied state of volatility and therefore dictate the next trade in our near future. Note how each triangle finally breaks into a new trend just as the Width line reaches an extreme low and reverses to the upside (circled below). This is typically considered the inflection point where a range becomes a trend and our view on the market must change accordingly.
Thomas Long, FX PowerCourse Instructor
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