What is Volatility?
A daily price change of 5%, compared to a historical average of 1%, represents a significant deviation from the norm and indicates increased volatility. Volatility indicators capture these moments and display them graphically.
In investing, volatility is synonymous with risk. Higher risk presents both dangers and opportunities.
Volatile markets typically exhibit rapid and larger-than-usual price changes. These periods, though rare, have a significant impact on returns. For instance, in the stock market, an upward cycle can last for years, but within months, equities can crash by up to 50%. These are times of pronounced volatility.
Volatility Indicators
Various volatility indicators help traders navigate successfully during high or low volatility periods. Bollinger Bands® and Average True Range (ATR) are among the most popular.
Bollinger Bands® (BB)
Bollinger Bands® is an indicator based on price volatility. BB forms a channel with three lines directly on the main chart. The middle line is a simple moving average (20 periods), and the outer lines are the +/- 2 standard deviations of this average (settings can be adjusted). Most of the time, these lines contain prices within their boundaries.
The standard deviation rises when volatility increases, causing the outer lines to widen. Conversely, the lines are closer during low-volatility periods. If a trend begins, prices may temporarily, or for more extended periods, move outside the BB boundaries.
This behavior is visible in the chart below.
Chart 1: Bollinger Bands. Source: MetaTrader4
Interpreting Bollinger Bands®
Bollinger Bands® should be interpreted according to traditional support and resistance rules: prices above the middle line indicate a bull market, while prices below it indicate a bear market. Consequently, when prices reach these lines, the BB will act as support or resistance.
The two border lines reflect two standard deviations of the average. Statistically, this means that prices close very rarely outside the boundaries. So, these end lines will be a supportive or resistive factor of last resort. Overcoming them most likely happens for a reason worth exploring. Strong trends usually involve a series of closing prices outside the BB borders.
Chart 2: Bollinger Bands Volatility Changes. Source: MetaTrader4
It is believed that the longer prices consolidate during a period of low volatility, the stronger the subsequent trend will be (Chart 2). The currency pair remained in balance for a considerable time, with buyers and sellers in equilibrium. However, when new significant information entered the market, prices began to move.
The trend is confirmed if prices close outside the boundary (e.g., declining prices below the lower line). The first signals of lost downside momentum occur when the pair closes back inside the boundaries. A trend reversal may be in play if prices close above the average (middle line).
The middle line, which acts as support in uptrends and resistance in downtrends, is often used by traders to join the trend, adjust their position size, or modify stop and take-profit orders.
However, a closing price outside the boundaries does not always mark the beginning of a trend. Further analysis is needed to determine the reliability of each signal. A breakout may occur for a single day (or over a specific period), followed by prices returning inside the boundaries in the next period. This is why volatility indicators, such as BB, are commonly used in mean-reverting strategies.
Chart 3: Bollinger Bands Support/Resistance Lines. Source: MetaTrader4
The chart shows that on several occasions, the price closed outside the boundaries, but the subsequent prices quickly returned inside the channel. In the latter case, the upward break led to a rise of several figures. Other indicators and technical analysis techniques might explain this moment. From a technical perspective, the break of the previous high provided further confirmation of the validity of this signal.
From a statistical perspective, prices are expected to fluctuate within +/- 2 standard deviations 95% of the time. Therefore, after an initial breakout of the boundaries, prices will likely return inside the channel, creating opportunities for mean-reverting strategies. However, as mentioned earlier, the most significant trends may occur during the remaining 5% of the time.
The main challenge is identifying situations with trading potential. BB is volatility indicator that do not generate signals in the literal sense but rather complement the overall picture. It is best used in conjunction with momentum or volume indicators. Synchrony between different indicators may recognize high-probability opportunities.
Many traders exploit the idea of support and resistance based on volatility. Adding a 1-standard deviation line in the BB is common, which offers additional reference points for managing positions.
Average True Range (ATR)
ATR is another popular technical indicator used to measure market volatility. It calculates the average range of price movements over a specified period (typically 14 days).
Chart 4: ATR High-Volatility (red) and Low-Volatility (green) periods. Source: MetaTrader4
Traders use the ATR to gauge how much an asset’s price typically moves within a given period (one day). This helps them manage risk more effectively.
The ATR does not indicate price direction but rather the degree of price movement. Higher ATR values suggest higher volatility, while lower values indicate lower volatility. Traders adjust their positions according to the current market environment.
Conclusion
High volatility is typically linked to high risk but can also present good investment opportunities. Indicators like Bollinger Bands® and ATR help identify these moments, enabling traders to manage their positions more efficiently.
