How to measure volatility

We often hear traders … market pundits … the man in the pub… taking about how volatile the markets are.

They’ll rub their chins and suck their teeth in a sage-like way… “you want to be careful with all this volatility about …”

Making some vague comment about market volatility is a fast ticket to sounding a bit knowledgeable about the markets. But what I want to look at today are reliable ways to measure volatility, so that you know exactly how volatile a market is.

We’re not guesstimating … we’re not squinting at the candlesticks …. Instead, by accurately measuring it, we can adapt our trading to match market conditions.

And the trader who is adaptable is always the one who’s going to come out in front.

What is volatility?

Volatility is nothing more complex than the up and down movement of the market.

If the market is experiencing big movements, then volatility is high.

If the market is moving very little, then volatility is low.

Volatility is strongly associated with falling markets. One of the main causes of volatility is a drop in the market. When markets fall, volatility typically shoots up until things quieten down again.

High volatility tends to scare people. And this fear can feed into the market behaviour – that’s what contagion is, and why markets will tend to make violent moves, and then we see corrections as things settle down.

Tools for the job

I’m going to look at three key tools that can be used to measure volatility. They each work differently.

Average True Range

The average true range (ATR) is a very effective measure of volatility – it tells us what the average trading range of the market is over a set number of periods.

So, if you want to gauge volatility over the last 14 days, you can look at a daily chart, set the ATR to 14, and you’ll see a measure at the bottom of your chart.

This shows the ATR14 on an hourly chart …

When the ATR is rising, it tells us that volatility is increasing. When it’s falling, it tells us that volatility is decreasing.

Bollinger bands

Bollinger bands don’t give us a “number” for our volatility – they’re a more visual interpretation of volatility. But no less useful or accurate.

Bollinger bands are calculated on standard deviation (i.e. how far something moves from the average). They form a “channel” shape around the price, and when they are wide apart, we have high volatility. When they are close together, we have low volatility.

The nice thing about Bollinger bands is that they can be used in other ways too, while the ATR is more of a one-trick pony.

The volatility index (also called VIX or “the fear index”)

The third tool I’m going to look at is a little different. It’s more of a “big picture” indicator that looks at volatility across a range of options on the S&P index, rather than in a specific instrument and timeframe of your choosing.

However, unlike the indicators we’ve looked at so far, it does claim to have predictive powers, measuring expected volatility over the coming 30 days …

Because of the close association of volatility with falling markets, the VIX is often used to predict bottoms on the S&P. So, if the VIX is rising, we expect to see the S&P falling.

The chart below compares the VIX reading with the S&P. As you can see, spikes on the VIX closely correlate to bottoms on the S&P.

How to use the information we’ve gained

Okay, so now we have a choice of ways to measure volatility – what do we do with that information?

While volatile markets are closely associated with fear in the market, it doesn’t mean that we need to shy away from them. Volatility means big moves – and that’s exactly where the best profits are to be made.

If markets are volatile, on the plus side, we can expect our profits to run further.

On the negative side, we’re more likely to get our stops hit by price swings.

Over the coming weeks I’ll be looking at ways to maximize the benefits of volatility, while protecting ourselves from the risks.

These will include ways that we can use trailing stops to let our profits run …

Ways we can avoid having our stops hit (and I’ve some much more creative ideas than simply widening them!)

So please watch out for much more info and some concrete tried-and-tested trading techniques coming up – including my video next week showing you a very cunning way to avoid the downside of stop losses.

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Related posts:

My 3 best volatility indicators Bollinger band strategy