Volatility is especially important for day traders; it’s hard to make money without frequent price fluctuations. But volatility is a two-edged sword—trades can go against you quickly. For that reason, it’s important to have an arsenal of technical indicators to help you tame the volatility beast.
Volatility indicators are unique in that they measure how far a security has moved away from mean directional value. A high volatility stock makes big moves from its average direction, while a low volatility stock stays close to the moving average.
Volatility indicators can be lumped into two main categories: Oscillators and channels. Oscillators move between two extreme values, typically 0 and 100, and build out a trend using the results. As long as the security trades within the established range, the oscillator’s signals are generally reliable, but false signals are a common pitfall when oscillators are used during a breakout.
Channels are overlays on the main trading chart that use volatility to predict the range in which the price should remain for a period of time. The theory behind channels is that when a price has moved too far from the average, traders react with moves in the opposite direction to bring the price back within range.
Of the oscillators, ATR is perhaps the most accurate volatility indicator. It is a pure volatility indicator and not a reflection of price. Although it doesn’t always point to a trend, it does reflect the nature of the market as a whole. It is a lagging indicator and may rise and fall in either an uptrend or a downtrend. Generally, ATR rises as the market consolidates into a definable trend, but you may actually see it fall when prices form into a trend.
Of the channel variety, two of the more popular are Bollinger Bands and Keltner Channels. Bollinger Bands create an envelope using the SMA and drawing +/- lines at two standard deviations. Keltner Channels use the EMA and ATR as the basis for the channel width. Traders using Bollinger Bands watch for the squeeze, a period of low volatility in which the channel narrows, constricting the SMA. This usually presages a period of high volatility in which to enter trades. When the bands are wide, a period of low volatility is usually forthcoming, signaling an exit.
Keltner Channels are generally smoother and narrower because ATR is less volatile than the SMA. As a trend following indicator, they are used to predict breakouts. A surge above the upper channel implies extreme strength, while a drop below it implies extraordinary weakness.
Volatility indicators form the basis of many profitable trading strategies, but you should never rely on volatility alone to make trade decisions.