Volatility is an important unseen part of the stock market. Unseen because this is an implied concept. Volatility means price fluctuation in the stock market. This happens within a short period of time. Volatility directly affects stock prices. Therefore volatility is tradable. In this article, we will discuss how we can trade volatility and what are the indicators used. We will discuss these indicators.
In a highly volatile market condition, retail traders often get caught with the wrong trades. A trader, therefore, needs to be aware of market volatility and consult volatility indicators while trading. There are trading techniques to tackle such situations in the stock market.
Here is the list of 12 volatility indicators you should learn:
Average True Range (ATR)
The average true range measures the volatility of a stock. ATR is a primary level volatility indicator. It is simple, easy to learn and easy to use.
By default, the indicator measures the 14-period range. It is plotted in a different panel below the price chart unless otherwise specified.
When the ATR reaches attains the highest value, the volatility is maximum. ATR measures the volatility of a stock. It is a lagging indicator.
Shown above the Nifty 50 daily chart. The ATR is plotted in the lower panel. A closer look reveals the peaks and troughs are indicative of price reversals. But these are just indications. There’s no other specific parameter to show the particular reversal points. Therefore when the ATR are at its highest or lowest points, the trader should be prepared for price reversals.
ATR is a simple indicator showing price volatility. It is very popular with Forex traders who are engaged in day trading mainly. Traders can also use stop-loss and target price targets depending on the strength of volatility.
The Keltner channel is a volatility-based indicator. Keltner channel uses ATR values to create the channel.
The Keltner Channel uses 20-period EMA to form the middle line on which the channel is based. Two times of ATR value are added with the exponential moving average value to form the upper band of the channel. Similarly, double the ATR value is subtracted from the exponential moving average to get the lower band of the channel.
When the price breaks out of the channel, it is expected that the trend will continue though there will be some profit-taking opportunities as well.
It is not like the Billinger Bands. It is much narrower and is interpreted in a different way. The channel expands and contracts with the rise and fall of volatility.
Bollinger Bands (BB)
The Bollinger Band (BB) is a volatility indicator as well as a trend indicator. Similar to the Keltner channel, it consists of three lines, the middle, upper and lower.
The middle bandle is a 20-period moving average, the upper band is created by adding a value of +2 standard deviation and the lower band by subtracting a -2 standard deviation value.
With variation in volatility, the bands expand or contract. Traders use it to find price reversal, trends and trading periods. When the price reaches or breaks any band, the price usually comes down, sooner or later.
The Donchian Channel is also a band-type volatility indicator. Like other bands, it also has three lines on which it is built. It is somewhat similar to two other bands we discussed earlier.
The median or the middle band is a moving average. The upper band is the highest prices over a specific period. The lower band is the lowest of prices over that specific period. It is usually calculated on a 4-week time scale. But the time scale can be set as per the trader’s need.
A trader uses the Donchian channel to identify trends and volatility of the stock prices. A trader can identify the bullish and bearish extremes of prices that favour reversal. Also, this channel helps to identify price breakouts and mean reversion. The midline or median is the mean reversion line.
The India VIX is an indicator that measures the index volatility on a scale. It is India Volatile Index. This was launched by the National Stock Exchange (NSE) in 2008.
This indicator basically represents the traders’ perception. When VIX is high, the volatility is high and there is a significant change in the Nifty. When the India Vix is low, the volatility perception is low. It indicates traders’ perception over the near term. It represents the near-term expectation by which the index is expected to fluctuate.
Here, in this diagram above, on the left side, the India VIX is plotted and the Nifty 50 chart on right. Their direction is completely opposite. The VIX chart has fallen down straight and at the same time, the Nifty has risen following just the opposite curve.
It shows that when the volatility was high the price was down. But people’s confidence grew, the Nifty 50 started rising, and the VIX fell. The VIX chart replicates people’s emotions. Traders were nervous, and the VIX was down, but when traders gained confidence on market and started investing more, VIX fell.
This indicator is based on the Nifty options price. It is calculated from the best Nifty options contracts’ bid-ask price, projecting the expected volatility for the next 30 days.
But as people’s expectations rise and fall, the VIX reading changes. For computation, the CBOE method is followed with necessary amendments to accommodate the Nifty 50 options pricing method.
Implied Volatility (IV)
Implied volatility is the future price movement forecast of price. It is denoted by sigma. It depends on certain predictive factors. The IV is usually expressed in percentages and standard deviation over a specific period of time.
When the market is bullish and less risky, the IV remains low. But during bearish phases of the market, when investing money seems risky, the IV rises sharply. When the implied volatility peaks, price reverses and a new bull run starts. The peaks and troughs in the IV scale coincide with price reversals.
Implied Volatility and options market
The options pricing is highly dependent upon the implied volatility. One of the main constituents of the options pricing model is dependent upon the implied volatility.
Though the IV is dependent on price, it does not depend on direction. The option pricing model is heavily dependent on implied volatility. The implied volatility isn’t a directly observable quantity. The implied volatility is the expected volatility in near future. But as we all know, nothing is certain in the future. Therefore the IV also has unpredictable factors in it. Implied volatility changes, it may change unpredictably.
When the IV value increases, the premium of options increases, irrespective of direction. That is, an increase in options IV increases the values of both Puts and Calls. A trader may sell options or buy options as per his/ her calculations. If the trader thinks volatility will come down in the future, he sells or if he thinks volatility will increase in the future, he may buy options.
Trading IV is not like trading equities in the cash segment. This involves an entirely new array of factors and calculations. We will discuss it in due course.
TTM Squeeze Indicator
The TTM Squeeze indicator is a volatility and momentum indicator. It has multiple uses. Some trading software like Tradingview and Thinkorswim charting platforms have already incorporated this indicator into their platform.
The TTM indicator uses both Bollinger Bands and Keltner channels in its application. When the stock price moves in such a way that the Bollinger Bands falls inside the Keltner channel, there occurs extreme low volatility in price. This is referred to as a volatility squeeze.
After the squeeze, the market gathers momentum and the Bollinger Bands expands and fires out of the Keltner channel. This is squeezing out when price breaks out of the Keltner channel and a trend starts.
The TTM Squeeze indicator is almost a complete indicator giving multiple signals to work with. There’s a lot to study on this indicator to make full use of it. We will discuss it in due course.
ARMs Index with TRIN Indicator
The ARMs Index and TRIN Indicator are the two names of the same indicator. It is a volatility indicator. It is also an oscillator because its value oscillates between upper and lower values. It also helps to predict upcoming price movements. It is one of the best indicators for intraday trades.
It compares the number of advance-decline stocks to the volume of advance-decline stocks. The formula for TRIN = Advancing Stocks / Declining Stocks ÷ Advancing Volume / Declining Volume
The interpretation of TRIN is easy. If the indicator value is more than 1, there is a chance for the price to decline. If TRIN is below 1, there’s a chance of a strong uptrend. It moves opposite to the price direction.
Relative Volatility Index (RVI)
The Relative Volatility Index (RVI) is a volatility indicator. For trend detection, it is best to use this indicator in conjunction with other trend indicators. It works as an oscillator also. It gives reading on a percentage scale. The scale is from 0 to 100.
The 50 marks line is considered the baseline of this indicator. RVI helps to identify the direction of volatility. If the reading in this indicator is above 50, it shows the volatility is on the upside. On seeing this signal the trader may buy a stock if another indicator confirms that.
Similarly, a reading below 50 shows the volatility is on the downside and traders may interpret that as a sell signal.
Only on the basis of the reading of this indicator is not a good bet. A trader must get confirmation from any other indicator before taking a trade.
Bollinger BandWidth (BBW) and %B
The Bollinger Bandwidth (BBW) and %B are two indicators based on Bollinger Bands. Both are actually derived from BB.
Bollinger BandWidth (BBW) indicator
BBW technical indicator informs the trader of the change in volatility. It is calculated by measuring the space between the upper and lower band divided by the median.
The BBW uses a single line instead of a band. When volatility increases, the width of BB increases, and the value of BBW also increases. And during congestion, the value of BBW falls. A trader can understand the amount of volatility by just looking at the indicator. At extreme low readings, the price is poised to break the shackles and shows a potential breakout from the zone.
The %B indicator is also derived from BB and uses three lines to interpret volatility. This indicator quantifies the relation of the price with volatility. It is a new indicator. It is extremely helpful for traders to interpret the trend and trading signals.
In the chart above, the use of all three indicators is explained. The %B indicator is extremely useful to a trader and generates a very efficient buy and sell signal.
Choppiness Index Indicator
The choppiness Index indicator is primarily a volatility indicator. And it also shows whether the market is trending or trading in a range. It shows whether the market is choppy and trading sideways or not. That’s why it is so named.
This indicator moves in a range of 0 to 100. When the reading is close to 100, it says the market is very choppy. And when the core is nearing zero, the market is trending.
There are two thresholds in this indicator. If the CHOP score is above 68.1, the analysts say that the stock is entering a choppy stage. If the value is below 38.2, the market is going to move in a trend.
A trader should keep in mind that if the indicator stays long in a consolidation phase or in a trending phase, there’s bound to come to a change. From the phase of consolidation, a trend starts. Longer the consolidation phase, the longer the trend. The opposite is also true.
Volatility Index or Cboe volatility index
The Volatility Index (VIX) or Cboe volatility index is similar to the India VIX. In fact, the India VIX was created from the idea of the Cboe (Chicago board of index) volatility index. This was created to quantify the traders’ sentiment trading in the S&P 500 Index (SPX).
This article has given an idea of volatility and volatility indicators. But as volatility is not an observable quantity like the price, it is to be understood more than visually seen. Some indicators have been developed to help traders by measuring volatility on their own scale. Directly you can not trade volatility. But there are trading measures to follow in conditions of high and low volatility.
Unless a trader understands the meaning of volatility, it will be hard for trading. Every volatility indicator must be interpreted deeply before using in trading. Usually, a volatility indicator alone is not enough for buy and sell signals unless used with other indicators. But there are a few which provide a lot of information, including entry and exit signals to a trader. Please check with the individual indicator subhead to study it deeply.