• Volatility Indicators
  • Standard Deviation
  • Bollinger Bands
  • Average True Range

What is Volatility?

  • Size and frequency of changes in the price of a security
  • The pace at which prices move, and how wildly they swing
  • Generally, changes in volatility tend to lead changes in prices
  • The higher the volatility, the riskier the security
  • Measured using standard deviation and other technical indicators

Standard Deviation

  • The most commonly used tool to measure volatility
  • Measures the difference between the actual price and its average value
  • The larger the volatility, the higher the standard deviation
  • Used to measure the price variation of a security and its relative risk

Standard Deviation - Calculation

  1. Calculate an x-period simple moving average
  2. Determine each period’s deviation (close minus average price)
  3. Sum the squares of each period’s deviation
  4. Divide this sum by the number of periods
  5. Calculate the square root of this result

Standard Deviation - Interpretation

  • Provides an estimate for expected price movements
  • Price moves greater than the Standard deviation show above average strength / weakness
  • These moves are used to spot overbought or oversold price conditions

Bollinger Bands Indicator

  • Bollinger bands indicator was named by its founder John Bollinger
  • A dynamic price channel that follows price movements and accommodates for volatility
  • Upper and lower bands are plotted two standard deviations above and below a moving average
  • Bands will be wider during increased volatility and narrower during decreased volatility

Bollinger Bands - Calculation

  • Middle Band = 20-period SMA
  • Upper Band=20 SMA + 2 standard deviations
  • Lower Band=20 SMA – 2 standard deviations

Interpretation - The Squeeze

  • When standard deviation has low values the bands squeeze and come near each other
  • When the bands squeeze it provides a signal that a large move, up or down, is to be expected
  • A bullish signal is given as the body of one of the candlesticks closes above the upper band
  • A bearish signal is given as the body of one of the candlesticks closes below the lower band

 

Interpretation - “W-Bottom”

  • A “M-Top” forms in an uptrend and indicates to a bearish reversal
  • A top forms above the upper band
  • There is a correction towards the middle band
  • A new top is formed below the upper band
  • The pattern is only confirmed after a move below the last bottom

Interpretation - Price Targets

  • Bollinger bands also show whether prices are relatively high or low
  • Reaching the upper or lower bands indicates the movement is far-fetched and a correction is expected
  • If after reaching the upper band prices cross below the 20 period average, the lower band becomes the target
  • If after reaching the lower band prices cross above the 20 period average, the upper band becomes the target

Interpretation - Walking the bands

  • During a strong trend prices can move alongside the bands without correcting in the opposite direction
  • This is what is known as “walking-the-bands”
  • Strong trending prices will fluctuate between the upper/lower band and the 20-period moving average
  • A crossing beyond the moving average alerts for a trend reversal to the opposite side

Average True Range

  • A volatility indicator that was developed by J. Welles Wilder
  • Using a volatility formula based only on the high-low range, will fail to capture volatility from price gaps
  • Wilder created Average True Range to capture this  “missing” volatility
  • ATR does not provide an indication of price direction,  just volatility

True Range - Calculation

Average True Range - Interpretation

High ATR values can warn traders of potential market tops and bottoms

Low ATR values indicate ranging markets

Many traders use the average true range as their initial stop loss

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