Volatility Indicators

What are Volatility Indicators?

Volatility indicators monitor changes in market price and compare them to historical values. In case the market price starts to change faster than would be appropriate according to the average of historical volatility or if the price crosses outside of a given range, the indicators will signal an oversold/overbought market. 

The Volatility technical indicator is helpful in seeing potential market reversals. This Volatility indicator based on the true range of price is based on the premise:

• Strong trends upward are marked by decreases in volatility.
• Strong trends downward show a general increase in volatility.
• Reversals in trend usually occur when volatility increases.

Uses of Volatility Indicators - 

The purpose of volatility-based indicators is very similar to the purpose of oscillators: to detect imbalances in the market and generate signals that can help us capitalize on these imbalances. These indicators also generate overbought/oversold signals.

If the price is rising too fast compared to the historical development, it can easily reach a stage in which the rise is no more sustainable. Volatility–based indicators inform us precisely about such situations. 

• A common trait of all volatility-based indicators is that they generate buy and sell signals that are based on the concept of overbought/oversold market (just like in case of oscillators). In case the price crosses above the upper bound of the range, in which it should be present according to the trends in historical data, a sell signal is generated. Conversely, if the price crosses under the lower bound of the range, a buy signal is generated. 

Pros and Cons of Volatility Indicator

• This type of indicators is constituted by the fact that they can clearly show that the rise or fall of the price is too steep as compared to previous periods and hence it is highly probable that it has either to slow down or stop completely. That's why these indicators can complement other technical analysis indicators quite well. 

• On the other hand, these indicators have the disadvantage of being based only on one thing – the price. They do not reflect any other data (for example as opposed to the volume-based indicators, which take into account both the price and the volume traded in the market). It is also possible that in case some extremely good news about company's fundamentals reaches the market, the price may keep rising in spite of all the signals generated by volatility-based indicators, as these do not reflect information about fundamentals. 

Types of Volatility Indicators explained - 

ATR ( Average True Range) - 

used to measure the volatility or the degree of price movement of a security. It was originally designed for commodity trading, which is frequently subject to gaps and limit moves. As a result, ATR takes into account gaps, limit moves, and small high-low ranges in determining the 'true' range of a commodity. However, the ATR are based on absolute values in price rather than percentage change. Therefore a commodity with a higher price tends to have a higher ATR than a lower priced commodity. ATR does not provide direction but is a strong indicator of a price break out as strong movements in the price of a security are often accompanied by large price ranges, especially at the beginning of a move. Thus, ATR can thus be used as an additional indicator to confirm a price break out. If the ATR is increasing, the support for a price breakout is also increasing.

ATR can also be used as a guide to determining stop loss levels as a security with a higher ATR will require a higher stop loss. 

Bollinger Bands - 

Bollinger Bands consist of three lines – a simple moving average (SMA), and two lines calculated at a specified number of standard deviations above and below the SMA. The bands indicate overbought and oversold levels relative to a moving average and can used to confirm trading signals.

During periods of volatility i.e., during increased price fluctuation, the upper and lower bands widen and when the price fluctuations decrease, the bands contract towards the price range. They can thus be used to compare volatility and relative price levels over a period of time.

Bollinger Bands do not give absolute buy and sell signals when prices reach the upper or lower bands, but indicate whether the price of the security is relatively high or low, allowing for more informed confirmation with other technical indicators.

Contracting bands indicate a possible trend though the first breakout is often a false move, preceding a strong trend in the opposite direction.

A move that begins at one band normally carries through to the other band when the security is trading within a range.

A move outside the band indicates a strong trend is strong and likely to continue but it can quickly reverse.

A close outside the band, followed by a close inside the band, indicates a trend reversal that is confirmed when the price moves across the center band.

Keltner Channel - 

Keltner Channels is a lagging volatility indicator that consists of 3 lines. However, the middle line in a Keltner Channel is an Exponential Moving Average (EMA)and the displacement of the two outer lines is base on the Average True Range (ATR) rather than on standard deviations.

The Keltner Channel also indicates overbought and oversold levels relative to a moving average, especially when the trend is flat, and can used to confirm trading signals. Because the channel is derived from the ATR, which is a volatility indicator, the Keltner Channel also contracts and expands with volatility but is not as volatile as the Bollinger Bands.

Thank You !