Volatility can seem like a scary concept at first glance: wild price swings, stop-outs, and general unpredictability. However, there are volatility technical indicators that can help. This article covers five essential volatility indicators, discussing how they work and how they’re used to gauge market conditions.
What Is Volatility?
Volatility represents the range and rate at which the price of a financial asset moves over a specific timeframe. In other words, it gauges the degree of variation in a trading price. High volatility often correlates with higher risks and potential rewards, while low volatility suggests a less turbulent market with lower risks and potential rewards.
Volatility Technical Indicators
Volatility indicators are specialised tools that help traders quantify these price swings, making it easier to forecast future movements. They can help traders identify potential breakouts or market reversals by revealing periods of accumulation or distribution. By providing a clearer understanding of market temperament, these indicators equip traders to make more calculated decisions – be it in forex, commodities, or stock markets.
These indicators can be overlaid on price charts to offer visual cues, thereby simplifying complex data. They are commonly used alongside other technical indicators like moving averages and momentum oscillators to reinforce their signals.
Best Volatility Indicators List
Now, let’s take a closer look at five of the best volatility indicators. To see how they work for yourself, head over to FXOpen’s free TickTrader platform. There, you’ll find each indicator ready to use.
Bollinger Bands are a volatility indicator invented by technical analyst John Bollinger in the 1980s. The indicator consists of three bands: a middle band, which is a simple moving average (SMA) of the asset's price, and two outer bands that are placed two standard deviations away from the middle band. These bands adjust dynamically with volatility, widening during periods of high volatility and contracting when volatility is low.
In trading, Bollinger Bands serve multiple purposes. They can identify overbought or oversold conditions when the asset's price reaches the upper or lower bands. The width of the bands also helps in recognising periods of increasing or decreasing volatility, often signalling potential market transitions. Traders frequently use Bollinger Bands to confirm trend reversals or to validate other technical signals.
Average True Range (ATR)
The Average True Range (ATR) is a volatility indicator introduced by J. Welles Wilder in 1978. Unlike Bollinger Bands, which envelop price action, ATR is a single line that typically appears below a price chart.
The indicator calculates the average of true ranges – essentially the greatest value among the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close – over a set number of periods.
ATR is primarily used for setting stop-loss levels and gauging the volatility of an asset. It doesn't offer any clues about price direction, making it a "pure" volatility measure. Higher ATR values indicate increased volatility and may suggest that price jumps or drops are more probable, warranting caution. Lower ATR values signify lower volatility, often seen during sideways market movements.
Keltner Channels are another volatility-based indicator, created by Chester Keltner in 1960 but later modified by Linda Raschke. This indicator consists of three lines: a central line, which is an Exponential Moving Average (EMA) of the asset's price, and two outer bands calculated based on the ATR. Typically, the outer bands are set two ATR values away from the central EMA.
Much like Bollinger Bands, the width of the Keltner Channels expands and contracts based on market volatility. These channels are particularly useful for identifying trend continuations and reversals. For instance, a price that moves toward the upper band often indicates bullish activity, whereas a movement toward the lower band suggests bearish behaviour.
Chaikin Volatility Indicator
The Chaikin Volatility Indicator, developed by Marc Chaikin, focuses on the expansion and contraction of price movement, differentiating it from other volatility indicators. Instead of using trading volume or calculating the average range, this indicator measures the difference between two EMAs of an asset's price, typically over 10 days.
When the Chaikin Volatility Indicator shows an upward movement, it indicates an increase in price volatility, potentially signalling a market breakout or a strong trend. Conversely, a downward trend in the indicator often suggests a decrease in volatility, possibly pointing to a market consolidation phase. Because this indicator focuses solely on price behaviour, traders often pair it with volume-based indicators for more comprehensive analysis and confirmation of trading signals.
Volatility Index (VIX)
The Volatility Index, commonly known as the VIX, operates somewhat differently from typical volatility trading indicators. Developed by the Chicago Board Options Exchange (CBOE), the VIX quantifies market sentiment and volatility expectations for the next 30 days. It is often referred to as the "fear gauge," as it tends to spike during periods of market unrest or uncertainty.
Calculated from the implied volatilities of S&P 500 index options, a high VIX value suggests that traders expect significant price swings, usually accompanying bearish market phases. On the other hand, a low VIX often indicates periods of complacency or confidence, generally correlating with bullish markets.
While not directly applicable to an asset's price chart, the VIX serves as one of the leading stock volatility indicators, offering traders context for broader market conditions.
The Bottom Line
In essence, volatility indicators are invaluable tools in a trader's arsenal, helping to demystify often unpredictable price movements. Mastering and combining these indicators, especially with momentum and trend tools, can significantly enhance your decision-making process.
To put these five tools into practice, consider opening an FXOpen account. We offer hundreds of tradable instruments and sophisticated charting tools, allowing you to navigate the markets with confidence.
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