Volatility Indicators

What is Volatility?

Volatility measures the size and frequency of changes in the price of a security. It is the pace at which prices move and how wildly they swing. Generally, changes in volatility tend to lead changes in price. The higher the volatility, the riskier the security.

Volatility is measured by using standard deviation or other technical indicators.

Standard Deviation

The standard deviation is the most commonly used tool to measure volatility. It measures the difference between the actual price and its average value. The larger the volatility, the higher the standard deviation.

  • Standard deviation is used to measure the price variation of a security and thus its relative risk.
  • It provides an estimate for expected price movements and hence the risk of a security.
  • Price moves greater than the standard deviation show above-average strength or weakness. These moves are used to spot overbought or oversold price conditions.

Calculating Standard Deviation (Example)

To calculate the standard deviation, first calculate an X-period Simple Moving Average (SMA). While the default period is usually 21, the following example uses a three-period moving average with closing prices of 75, 65, and 55.

  1. Calculate the SMA: Averaging the three closing prices (75, 65, 55) gives an average of 65.
  2. Determine each period's deviation from the average:
    • 75 - 65 = 10
    • 65 - 65 = 0
    • 55 - 65 = -10
  3. Sum the squares of each deviation: (-10 squared) + (0 squared) + (10 squared) equals 200.
  4. Divide this sum by the number of periods used: 200 divided by 3.
  5. Calculate the square root of this result: The resulting standard deviation is 8.16.

Bollinger Bands

Bollinger Bands were named after their founder, John Bollinger. He created this indicator to form a dynamic price channel that follows price movements and accommodates for volatility.

Construction

The indicator is made of three bands:

  • Middle Band: The 20-period Simple Moving Average (SMA).
  • Upper Band: Plotted two standard deviations above the 20-period SMA.
  • Lower Band: Plotted two standard deviations below the 20-period SMA.

Since standard deviation measures volatility, bands will be wider during increased volatility and narrower during decreased volatility.

Usage and Signals

  • The Squeeze: When standard deviation has low values, the bands squeeze and come near each other, implying low volatility. This signals that a large move (up or down) is to be expected, as low volatility often precedes high volatility.
  • Trend Breakouts:
    • A bullish signal is given as soon as the body of a candlestick closes above the upper Bollinger band.
    • A bearish signal is given as the body of a candlestick closes below the lower Bollinger band.
  • Reversal Patterns:
    1. W Bottom (Bullish): Forms in a downtrend. A bottom forms below the lower band, followed by a bounce toward the middle band, and then a new bottom forms above the lower band. The pattern is confirmed after a move above the last top.
    2. M Top (Bearish): Forms in an uptrend. A top forms above the upper band, followed by a correction toward the middle band, and then a new top forms below the upper band. The pattern is confirmed after a move below the last bottom.
  • Relative Price Levels: Reaching the upper or lower bands indicates the movement is extended and a correction is expected.
    • If prices cross below the 20-period average after reaching the upper band, the lower band becomes the target.
    • If prices cross above the 20-period average after reaching the lower band, the upper band becomes the target.
  • Walking the Bands: During a strong trend, prices can move alongside the upper or lower bands with many touches without correcting substantially. A crossing beyond the 20-period moving average alerts for a trend reversal to the opposite side.

Average True Range (ATR)

The Average True Range (ATR), developed by J. Wells Wilder, captures volatility that includes price gaps, addressing the failure of simpler high-low range formulas. ATR does not provide an indication of price direction; it measures only volatility.

The ATR is typically a moving average of the True Range for a specific time period, usually 14 periods.

Defining True Range

True Range is defined as the greatest of the following three values:

  • Current High minus Current Low
  • Current High minus Previous Close
  • Current Low minus Previous Close

ATR Trading Signals

  • High ATR values: Can warn traders of potential market tops and bottoms.
  • Low ATR values: Can indicate ranging markets.
  • Many traders use ATR as their initial stop loss placement.
  • Trend Confirmation:
    • A bullish reversal with an increase in ATR shows strong buying pressure and reinforces the reversal.
    • A bearish support break with an increase in ATR shows strong selling pressure and reinforces the support break.