What Are Volatility Indicators & How To Trade Them

Volatility Indicators

Volatility indicators are a type of technical analysis tool that are used to try and determine the overall market volatility and for potential exit and entry points into the markets.

What are Volatility indicators?

Market volatility moves in cycles of highs and lows. Volatility tells traders about the direction of the current market and indicates future price movements.

Traders need to look for different kinds of volatility for price movements: They are:

  • Historical volatility – calculated from previous price changes.
  • Future volatility – makes predictions about future movements.
  • Forecast volatility – an overall estimate of future volatility.
  • Implied volatility – a type of volatility used in the options market.

To measure volatility, one has to rely on variance and standard deviation. The SD is the square root of variance.

There is a fear among the participants in a highly volatile market, which is considered a risky trade. However, this is the time when most traders enter buy positions in anticipation of higher prices. On the other hand, when there is low volatility, traders often take short positions.

Types of Volatility indicators

There are many types of volatility indicators. Some of the well-known are:

1. CBOE Volatility Index

CBOE is one of the best measurers of market volatility. Introduced by the Chicago Board of Exchange in the 1990s, the CBOE Volatility Index is used in S & P 500 Index. The CBOE Volatility Index is also known as VIX.

The VIX measures the volatility between 12-period and 35-period. When the values are higher than 30, it’s an indication of increasing volatility. Conversely, when the values are lower than 20, it’s a sign of decreasing volatility.

VIX indicator
VIX indicator

2. Average True Range

Average True Range, a.k.a. ATR, is a technical indicator developed by J. Welles. Unlike the VIX, the ATR works on every financial market.

The ATR indicator calculates the true range and then produces the 14-day EMA (exponential moving average) of this true range. To find the true range, the following equations are used:

True range = Current day’s high minus the current day’s low.

True range = Current day’s high minus the previous day’s close.

True range = Previous day’s close minus the current day’s low.

The ATR indicator is created as an EMA is then created as an EMA by applying the above-mentioned true range equations. If the value of ATR is greater, than there is a chance of increasing volatility. Conversely, if the value of ATR is lower, it is a sign of low volatility.

ATR on a chart
ATR on a chart

3. Bollinger Bands

Bollinger Bands is considered one of the most popular types of volatility indicators. It consists of two lines, which are called bands. These bands compromises of two 20-day moving averages.

When there is greater volatility, the bands widen, and when there is low volatility, the bands shrink. This characteristic makes Bollinger Bands’ a favorite among beginner traders. Moreover, it can work on every type of market.

Bollinger Bands on a chart
Bollinger Bands on a chart

How to use volatility indicators?

Every type of trader can take advantage of volatility indicators. When there is low volatility, it is suitable for long-term traders, as there would be a steady market growth. On the other hand, when the market is highly volatile, short-term traders can take positions because of choppy price action.

The volatility indicators can tell a trader about three things:

  • Market reversals
  • Gauging the strength or weakness of a trend
  • Finding breakout regions

Volatility Indicators conclusion

Volatility Indicators are a way to find overall market conditions for short term and long term trading. Volatility Indicators can be used on your trading platform charts to help filter potential trading signals as part of an overall trading strategy.

I would prefer to use the majority of market analysis such as Volatility Indicators on the 1-hour charts and above. I tend to find that these charts contain less market noise than the lower time frames and thus give more reliable signals for my forex trading strategies. This also means that I spend less time staring at charts and can also set alert notifications to let me know when price has reached certain levels, candlestick pattern has been formed or a particular indicator value has been reached.

Volatility Indicators are just one method of market analysis amongst thousands. I would not build a trading system alone, but rather combine with other technical indicators such as moving averages, Parabolic SAR, Stochastic Oscillator, RSI, ADX and price action analysis.

Of course, every trading system will generate false signals which is why money management is so important. I would personally be implementing sensible money management and only take traders that give me a favorable risk to reward ratio, ideally of at least 1:3. This means that one losing trade does not wipe out consecutive winners.

The methods of implementing Volatility Indicators into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.

Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.

If you would like to practice trading with Volatility Indicators, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.

Happy trading!