- November 30, 2021
- Posted by: NetPicks
- Category: Trading Article
The natural rhythm of the market is trending and consolidation. Those are important but so is the volatility of the instrument you are trading.
This is where understanding and using volatility indicators can help you trade more effectively and keep your expectations in check.
Knowing what the historical volatility that your instruments have, can help a trader determine if they should trade.
2 Different Volatility Levels
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.
Your trading system may do better with one level than it will with another:
- 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 are no technical indicators to use so don’t spend too much time picking and tweaking the indicator. Apply it to your chart using the standard setting and that should help you begin to learn how to see volatility in price action.
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.
When the ATR increases, especially rapidly, you are seeing volatility hit the market.
Once the ATR rises as volatility increases, traders may want to give their protective stops a little breathing space. Getting ticked out on a wild swing can be painful.
- We may see ATR rise as the market moves from a tight consolidation to a strong trend
- 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.
Look at the size of the candlesticks during a rapid rise in ATR.
The ATR is not perfect
- 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.
Often times, when you see these spikes, you may be on alert for a reversal of price.
Bollinger Bands, from John Bollinger, are calculated based on the distance of price from a moving average over a specified number of bars, typically 20.
The high and low bands are generally 2 standard deviations from that moving average
If the price deviation follows a normal distribution, that means that 95% of the normal price fluctuation should be contained within the bands.
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.
Trading signals using the information the Bollinger Bands is telling us could be:
- Wait for price to poke outside the lower band or upper band, 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. Price is at a high risk of reversing when extended.
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.
Volatility Index – VIX
Probably one of the most popular volatility indicator is the VIX otherwise known as the Cboe Volatility Index.
The calculation uses an options price model and shows what the current or expected volatility is. Large institutional investors hedge their portfolios using S&P 500 options. A calculation using strikes prices, put/call ratio, and expiry dates gives us the reading.
Those readings indicate whether those that move the markets are looking bullish or bearish.
In a nutshell,
- Less than 12 is a period of low volatility
- Around the 20 level is an acceptable period of medium volatility
- 30 and above is a time to search out less risky assets
The VIX is not a guarantee and price can do whatever it wants. However, the VIX is looked at as a weather gauge about how investors feel about the market in general over a short time period.
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 and even free charts. I encourage you to experiment with them and observe them in action keeping in mind your trading time frame.
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. Trading highly volatile markets comes with an increase risk of losses.
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.