What Are Volatility Indicators & How To Trade Them

Volatility indicators are a type of technical analysis tool that are used to try and determine the overall market volatility and for potential exit and entry points into the markets. Volatility indicators can be excellent tools for identifying market transitions from high periods of volatility to low periods of volatility. These indicators when combined with other trending indicators such as momentum or technical indicators can form the basis of a flexible trading system. Some of the most commonly used tools to gauge relative levels of volatility are the Cboe Volatility Index (VIX), the average true range (ATR), and Bollinger Bands. Forex market volatility is largely caused by uncertainty, which can be influenced by interest rates tax changes, inflation rates, and other monetary policies but it is also affected by industry changes and national and global events.

What are Volatility indicators?

Market volatility moves in cycles of highs and lows. Volatility tells traders about the direction of the current market and indicates future price movements.

Traders need to look for different kinds of volatility for price movements: They are:

  • Historical volatility – calculated from previous price changes.
  • Future volatility – makes predictions about future movements.
  • Forecast volatility – an overall estimate of future volatility.
  • Implied volatility – a type of volatility used in the options market.

To measure volatility, one has to rely on variance and standard deviation. The SD is the square root of variance.

There is a fear among the participants in a highly volatile market, which is considered a risky trade. However, this is the time when most traders enter buy positions in anticipation of higher prices. On the other hand, when there is low volatility, traders often take short positions.

Types of Volatility indicators

There are many types of volatility indicators. Some of the well-known are:

1. CBOE Volatility Index

CBOE is one of the best measurers of market volatility. Introduced by the Chicago Board of Exchange in the 1990s, the CBOE Volatility Index is used in S & P 500 Index. The CBOE Volatility Index is also known as VIX.

The VIX measures the volatility between 12-period and 35-period. When the values are higher than 30, it’s an indication of increasing volatility. Conversely, when the values are lower than 20, it’s a sign of decreasing volatility.

VIX indicator
VIX indicator

2. Average True Range

Average True Range, a.k.a. ATR, is a technical indicator developed by J. Welles. Unlike the VIX, the ATR works on every financial market.

The ATR indicator calculates the true range and then produces the 14-day EMA (exponential moving average) of this true range. To find the true range, the following equations are used:

True range = Current day’s high minus the current day’s low.

True range = Current day’s high minus the previous day’s close.

True range = Previous day’s close minus the current day’s low.

The ATR indicator is created as an EMA is then created as an EMA by applying the above-mentioned true range equations. If the value of ATR is greater, than there is a chance of increasing volatility. Conversely, if the value of ATR is lower, it is a sign of low volatility.

ATR on a chart
ATR on a chart

3. Bollinger Bands

Bollinger Bands is considered one of the most popular types of volatility indicators. It consists of two lines, which are called bands. These bands compromises of two 20-day moving averages.

When there is greater volatility, the bands widen, and when there is low volatility, the bands shrink. This characteristic makes Bollinger Bands’ a favorite among beginner traders. Moreover, it can work on every type of market.

Bollinger Bands on a chart
Bollinger Bands on a chart

How to use volatility indicators?

Volatility indicators can be excellent tools for identifying market transitions from high periods of volatility to low periods of volatility. These indicators when combined with other trending indicators such as momentum or technical indicators can form the basis of a flexible trading system.

Every type of trader can take advantage of volatility indicators. When there is low volatility, it is suitable for long-term traders, as there would be a steady market growth. On the other hand, when the market is highly volatile, short-term traders can take positions because of choppy price action.

The volatility indicators can tell a trader about three things:

  • Market reversals
  • Gauging the strength or weakness of a trend
  • Finding breakout regions

Volatility is a two-sided coin when it comes to forex trading. On the one hand, volatility is how forex traders are able to turn a profit, especially when looking to make a quick buck off of short-term trades.

On the other hand, increased volatility means less certainty about the market’s movements. When you’re trying to make trades based on your best understanding of market trends, you don’t want to get caught by surprise by market volatility that moves prices in a direction you didn’t anticipate.

If you want to capitalize on volatility in the market, it’s helpful to lean on popular volatility indicators that can help you make sense of the chaos appearing on forex charts.

This is a good thing: You couldn’t make money as a trader if prices never changed. Sometimes prices move more quickly than at other times. The speed or degree of the price change (in either direction) is called volatility. As volatility increases, the potential to make more money quickly, also increases.

Volatility Indicators conclusion

Volatility measures the degree to which price moves over time, generating non-directional information unless the data is plotted in specific visual formats. This technical element has a great impact on options pricing and market sentiment, with high volatility generating greater extremes in greed and fear. Constructed as an indicator, volatility plots a history of price movement that supplements trend, momentum, and range analysis. Higher stock price volatility often means higher risk and helps an investor to estimate the fluctuations that may happen in the future.

Volatility Indicators are a way to find overall market conditions for short term and long term trading. Volatility Indicators can be used on your trading platform charts to help filter potential trading signals as part of an overall trading strategy.