The natural rhythm of the market is not only trending and consolidation but we have to also deal with different types of volatility. This is where understanding and using volatility indicators can help you trade more effectively and keep your expectations in check.
Volatile periods in the markets can, in the worst scenario, create wild and sharp swings in the markets which can make them difficult to trade. We often see extreme volatility after certain news releases and world events that are extreme in nature and this type of action is easily seen on the chart.
Volatility can be more subtle which we see during extended runs during trending markets and more muted volatility during the consolidation phase of the market. Each of these types of environments are going to have different types of market approaches that can be used.
- Trending types of systems looking to take advantage of individual swings or longer positions until there is a change in trend
- Breakout systems will take advantage of the volatility that arises when there is a true breakout of a consolidation
- You can utilize a channel trading system which can be trend line channels or some types of bands
- Reversion systems will have you taking positions when markets reach a support or resistance zone the contains the consolidation
Knowing what phase the market is in will assist you in using the “right tool” for the job. You probably don’t want to look for longer term trending plays inside of a low volatility consolidation area. You would be letting positions ride when the reversal takes place which will have detrimental impact on your trading account.
Inside of every charting platform, there are tools called volatility indicators that will help you objectively measure the level of the volatility and it’s important to fully understand the tool you are going to use. Keep in mind there is no best volatility indicator to use so don’t spend too much time picking and tweaking the indicator. This applies to any market including Forex and Futures. Apply it to your chart using the standard setting and that should help you begin to learn how to see volatility in price action.
Using ADX As A Volatility Indicator
The ADX indicator measures the strength of a trend based on the highs and lows of the price bars over a specified number of bars, typically 14. Generally an ADX crossing of the 20 or 25 levels is considered the beginning of a trend, either an uptrend or a downtrend. A move down in the ADX is considered to signal the end of a trend. While the ADX is below 20 or 25 the market is usually in a consolidation.
As long as ADX continues to rise, the trend remains strong, but once it starts to turn down the trend is weakening. This chart shows a strong trend in place on the left and as price is showing consolidation periods and no strong price thrusts, the ADX peaks and is s sloping downwards with occasional upturns. This can objectively show you that the strength of the move has softened and any positions in the price trend direction should be managed closely.
The far right of the chart we see an upturn from below 20 with an upturn in the ADX. This can indicate the volatility has returned to the market and you may want to adapt your trading approach to suit the new reality.
The ADX has two drawbacks that you must be aware of before thinking you’ve found the holy grail of trading.
- It does not indicate the direction of the trend. For that it’s often combined with the Directional Indicator (+DI and –DI) and as a matter of fact the ADX calculation is based on the DI. It’s easy enough however to determine the trend visually of with the use of a simple moving average or using the typical trending price description.
- As is the case with most trading indicators the ADX is a lagging indicator. It signals the beginning or end of a trend after the fact. With proper risk management however that can still allow us to profit from the bulk of a strong move.
Compare the move of the ADX and the condition of price in the graphic and see what else you can learn from this chart that may apply to your trading.
ATR – Average True Range Indicator
The ATR measures the true range of the specified number of price bars, again typically 14. The true range differs from a simple range in that it includes the close of the prior bar in its calculation.
ATR is a pure volatility measure and does not necessarily indicate a trend. It’s quite possible to have volatile price movement inside a choppy market, as is often the case during an important news event.
The best way to use the ATR is as an indication of a change in the nature of the market. We may see ATR rise as the market moves from a tight consolidation to a strong trend or we may see ATR fall as the market transitions from choppy price action into a smooth, strong trend. This chart shows a couple of examples where ATR actually falls as price begins to trend, and drops as price enters some choppy consolidation.
The ATR has the same drawbacks as the ADX.
- It does not indicate direction, so we often see a rising (or falling) ATR in both an uptrend and a downtrend
- It is a lagging indicator so it will not catch the very beginning or end of a market transition.
- The ATR will not work with range, momentum or Renko bars. Since those are all constant range bars the ATR will essentially be flat and equal to the constant range.
Using Bollinger Bands As A Volatility Measure
Bollinger Bands are calculated based on the distance of price from a moving average over a specified number of bars, typically 20. The bands are a fixed number of standard deviations above and below the moving average, usually two standard deviations. If the price deviation follows a normal distribution that means that 95% of the normal price fluctuation should be contained within the bands, so a breakout from the bands implies a move outside of that 95% probability range, or an increase in volatility.
Direction and Volatility
Unlike ADX and ATR, Bollinger Bands indicate both volatility and direction. When price volatility is high the bands widen, when it’s low the bands tighten. Since it’s possible to have high volatility during consolidation, typically choppy periods will have wide bands moving sideways, as shown in the highlighted section labelled “A”.
When prices transition into a trend, the bands will widen and slope up or down, as shown in the area marked “B”. As long as price continues to hug the upper or lower band the trend remains strong, but once price drops away from the bands the market is typically entering a consolidation phase or possibly reversing. You can clearly see these transitions in the chart but I have highlighted small retraces in price to the moving average inside the bands.
A simple trading method using the information the Bollinger Bands is telling us could be:
- Wait for price to poke outside the bands which indicates a large deviation from normal price hence volatility
- Price pulls back to the area around the 20 period moving average (there is no magic here)
- Look for a price pattern to indicate a reversal in price
I put together a post on a trading system that uses the same idea but utilizes Keltner Channels for the volatility and the price pullback measure. I also compare the differences between the two indicators: Simple Keltner Channel Trading Strategy
Bollinger Bands are an excellent volatility and trend indicator but like all indicators, they are not perfect. They also lag price action so they will not catch the very beginning or end of a trend. To be fair, you don’t need to catch the exact turning point but you also don’t want to be taking positions when the move has had a significant run.
They can also signal false transitions as shown in the zone marked “A”, where price bounces between the bands. Although clear in hindsight, at the time price touches the bands it’s not clear if it signals the start of a trend or the beginning of a fading move or reversal.
This is not a single volatility indicator but combines both the Keltner Channel and the Bollinger Bands. It takes full advantage of the difference in the way both indicators measure and react to changes in volatility which can assist you in determining true breakouts as well as the end of a trending move.
This is a special technique and Netpicks has put together a standalone article on this topic so you can better understand and utilize this technique called the Bollinger Band squeeze.
Apply These Indicators To Your Trading
These have been just a few volatility indicators commonly available in all charting platforms. I encourage you to experiment with them and observe them in action. They can be excellent tools to identify market transitions, and combined with other trending indicators or oscillators could form the basis of a flexible trading system.
Keep in mind that nothing is perfect and optimizing indicators such as these used for volatility can have you curve fitting a trading system. This is a dangerous practice and one you should avoid at all costs. You should read: How To Avoid Curve Fitting During Back Testing which will give you concrete steps you can take to ensure the viability of a trading system.
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