Volatility Indicators Overview
Volatility-based indicators are valuable technical analysis tools that look at changes in market prices over a specified period of time. The faster prices change, the higher the volatility. The slower prices change, the lower the volatility.
It can be measured and calculated based on historical prices and can be used for trend identification. It also typically signals if a market is overbought or oversold (meaning price is unjustifiably high or unjustifiably low), which can point to a stalling or reversal of the trend.
Identifying the points where price potentially stops and reverses is very helpful to any trader. They are commonly used in combination with other signal-generating conditions. There are several volatility-based indicators all using volatility in a clever way to help identify trading opportunities.
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Note: In case you like to trade with free trend-based indicators, this guide will cover the most notable ones.
Average True Range (ATR)
The average true range (ATR) is a technical analysis indicator, introduced by market technician J. Welles Wilder Jr. in his book "New Concepts in Technical Trading Systems", that measures market volatility by decomposing the entire range of an asset price for that period.
Impotant Points To Remember:
- The average true range (ATR) is a market volatility indicator used in technical analysis.
- It is typically derived from the 14-day simple moving average of a series of true range indicators.
- The ATR was originally developed for use in commodities markets but has since been applied to all types of securities and assets.
The true range indicator is taken as the greatest of the following: current high less the current low; the absolute value of the current high less the previous close; and the absolute value of the current low less the previous close. The ATR is then a moving average, generally using 14 days, of the true ranges.
Traders can use shorter periods than 14 days to generate more trading signals, while longer periods have a higher probability to generate fewer trading signals.
For example, assume a short-term trader only wishes to analyze the volatility of a stock over a period of five trading days. Therefore, the trader could calculate the five-day ATR.
Assuming the historical price data is arranged in reverse chronological order, the trader finds the maximum of the absolute value of 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.
These calculations of the true range are done for the five most recent trading days and are then averaged to calculate the first value of the five-day ATR.
Using The ATR
Wilder originally developed the ATR for commodities, although the indicator can also be used for stocks and indices. Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR.
The ATR may be used by market technicians to enter and exit trades, and is a useful tool to add to a trading system. It was created to allow traders to more accurately measure the daily volatility of an asset by using simple calculations. The indicator does not indicate the price direction; rather it is used primarily to measure volatility caused by gaps and limit up or down moves. The ATR is fairly simple to calculate and only needs historical price data.
The ATR is commonly used as an exit method that can be applied no matter how the entry decision is made.
The ATR can also give a trader an indication of what size trade to put on in derivatives markets. It is possible to use the ATR approach to position sizing that accounts for an individual trader’s own willingness to accept risk as well as the volatility of the underlying market.
Limitations Of ATR
There are two main limitations to using the ATR indicator.
The first is that ATR is a subjective measure, meaning that it is open to interpretation. There is no single ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead, ATR readings should always be compared against earlier readings to get a feel of a trend’s strength or weakness.
Second, ATR only measures volatility and not the direction of an asset’s price. This can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points. For instance, a sudden increase in the ATR following a large move counter to the prevailing trend may lead some traders to think the ATR is confirming the old trend; however, this may not actually be the case.
Bollinger Bands (BB)
Bollinger Bands Overview
A Bollinger Band is a technical analysis tool defined by a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security’s price, but which can be adjusted to user preferences.
Bollinger Bands were developed and copyrighted by famous technical trader John Bollinger, designed to discover opportunities that give investors a higher probability of properly identifying when an asset is oversold or overbought.
Impotant Points To Remember:
- Bollinger Bands are a technical analysis tool developed by John Bollinger for generating oversold or overbought signals.
- There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band.
- The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average, but they can be modified.
Bollinger Bands Calculation
The first step in calculating Bollinger Bands is to compute the simple moving average of the security in question, typically using a 20-day SMA.
A 20-day moving average would average out the closing prices for the first 20 days as the first data point. The next data point would drop the earliest price, add the price on day 21 and take the average, and so on.
Next, the standard deviation of the security’s price will be obtained. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting, and finance.
For a given data set, the standard deviation measures how spread out numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance, which itself is the average of the squared differences of the mean.
Next, multiply that standard deviation value by two and both add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.
Using The Bollinger Bands
Bollinger Bands are a highly popular technique. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. John Bollinger has a set of 22 rules to follow when using the bands as a trading system.
The 22 Rules Of Bollinger Bands:
The squeeze is the central concept of Bollinger Bands. When the bands come close together, constricting the moving average, it is called a squeeze.
A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or in which direction the price could move.
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal.
The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.
Limitations Of Bollinger Bands
Bollinger Bands are not a standalone trading system. They are simply one indicator designed to provide traders with information regarding price volatility.
John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data.
Because they are computed from a simple moving average, they weigh older price data the same as the most recent, meaning that new information may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every situation. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.
Keltner Channel (KC)
Keltner Channel Overview
Keltner Channels are volatility-based bands that are placed on either side of an asset’s price and can aid in determining the direction of a trend.
The Keltner channel uses the average-true range (ATR) or volatility, with breaks above or below the top and bottom barriers signaling a continuation.
Important Points To Remember:
- Keltner Channels are volatility-based bands that are placed on either side of an asset’s price and can aid in determining the direction of a trend.
- The exponential moving average (EMA) of a Keltner Channel is typically 20 periods, although this can be adjusted if desired.
- The upper and lower bands are typically set two times the average true range (ATR) above and below the EMA, although the multiplier can also be adjusted based on personal preference.
- Price reaching the upper Keltner Channel band is bullish, while reaching the lower band is bearish.
- The angle of the Keltner Channel also aids in identifying the trend direction. The price may also oscillate between the upper and lower Keltner Channel bands, which can be interpreted as resistance and support levels.
Understanding The Keltner Channel
The Keltner Channel was first introduced by Chester Keltner in the 1960s. The original formula used simple moving averages (SMA) and the high-low price range to calculate the bands. In the 1980s, a new formula was introduced that used average true range (ATR). The ATR method is commonly used today.
The Keltner Channel is a volatility-based technical indicator composed of three separate lines. The middle line is an exponential moving average (EMA) of the price. Additional lines are placed above and below the EMA. The upper band is typically set two times the ATR above the EMA, and the lower band is typically set two times the ATR below the EMA. The bands expand and contract as volatility (measured by ATR) expands and contracts.
Since most price action will be encompassed within the upper and lower bands (the channel), moves outside the channel can signal trend changes or an acceleration of the trend. The direction of the channel, such as up, down, or sideways, can also aid in identifying the trend direction of the asset.
Keltner Channel Methods
Keltner Channels have multiple uses and how they are used will largely depend on the settings a trader uses. A longer EMA will mean more lag in the indicator, so the channels won’t respond as quickly to price changes. A shorter EMA will mean the bands react quickly to price changes but will make it harder to identify the true trend direction.
A bigger multiplier of the ATR to create the bands will mean a larger channel. The price will hit the bands less often. A smaller multiplier means the bands will be closer together and the price will reach or exceed the bands more often.
Traders can set up their Keltner Channels any way they like, with the following potential uses in mind:
The angle of the channel helps to identify trend direction. A rising channel means the price has been rising, while a falling or sideways channel indicates the price has been falling or moving sideways, respectively.
A price move above the upper band shows price strength. This is another indication that an uptrend is in play, especially if the channel is angled upwards.
A drop below the lower band shows price weakness. This is evidence of a downtrend, especially if the channel is angled downward.
If the price is continually hitting the upper band, but not the lower, when the price does finally reach the lower band it could be a sign that the uptrend is losing momentum.
If the price is constantly hitting the lower band, but not the upper, when the price does finally reach the upper band it could be a signal that the downtrend is near an end.
The price may also oscillate between the upper and lower bands. In cases like these, traders may use the bands as support and resistance. They may look to buy when the price reaches the lower band and then starts to move higher again and may look to sell or short after the price starts to fall again after reaching the upper band.
After a sideways period, if the price breaks above or below the channel and the channel starts to angle the same way, that may signal that a new trend is underway in that breakout direction.
Keltner Channel Calculation
/* EMA=Exponential moving average (typically over 20 periods) ATR=Average True Range (typically over 10 or 20 periods) */ Keltner Channel Middle Line = EMA Keltner Channel Upper Band = EMA + 2 * ATR Keltner Channel Lower Band = EMA − 2 * ATR
Keltner Channel Limitations
The usefulness of the Keltner Channels largely depends on the settings used. Traders first need to decide how they want to use the indicator and then set it up to help accomplish that purpose. Some of the uses of Keltner Channels, addressed above, won’t work if the bands are too narrow or too far apart.
While Keltner Channels can help identify trend direction, and even provide some trade signals, they are best used in conjunction with price action analysis, fundamentals if trading for the long term, and other technical indicators.
The bands may also not act as support or resistance and they may seem to have little forecasting ability at all. This could be due to the settings chosen, but there is also no evidence that the price moving two ATRs or hitting one of the bands will result in a trading opportunity or something significant happening.
Donchian Channel (DC)
Donachian Channel Overview
Donchian Channels are three lines generated by moving average calculations that comprise an indicator formed by upper and lower bands around a midrange or median band.
The upper band marks the highest price of a security over N periods while the lower band marks the lowest price of a security over N periods. The area between the upper and lower bands represents the Donchian Channel.
Career futures trader Richard Donchian developed the indicator in the mid-20th century to help him identify trends. He would later be nicknamed "The Father of Trend Following."
Important Points To Remember:
- Donchian Channels are a technical indicator seeks to identify bullish and bearish extremes that favor reversals as well as higher and lower breakouts, breakdowns, and emerging trends.
- The middle band simply computes the average between the highest high over N periods and the lowest low over N periods.
- These points identify the median or mean reversion price.
Donchian Channel Calculation
- Upper Channel (UC) = Highest High in Last N Periods
- Middle Channel (MC) = (UC + LC) / 2
- Lowest Channel (LC) = Lowest Low in Last N periods
Using Donchian Channels
Donchian Channels identify comparative relationships between the current price and trading ranges over predetermined periods. Three values build a visual map of price over time, similarly to Bollinger Bands, indicating the extent of bullishness and bearishness for the chosen period. The top line identifies the extent of bullish energy, highlighting the highest price achieved for the period through the bull-bear conflict.
The center line identifies the median or mean reversion price for the period, highlighting the middle ground achieved for the period through the bull-bear conflict. The bottom line identifies the extent of bearish energy, highlighting the lowest price achieved for the period through the bull-bear conflict.
Limitations Of Donchian Channels
Markets move according to many cycles of activity. An arbitrary or commonly used N period value for Donchian Channels may not reflect current market conditions, generating false signals that can undermine trading and investment performance.