Price is the most important measure in any market. But the volatility of that price can give you an overview about price over the long term and give you a sense of where the market is, or is not, heading.
What are Volatility Based Indicators?
Volatility based indicators are technical indicators that tell you the variability of price over time. The more volatile a market, the higher the probability the price could vary significantly from where it is now.
This is especially important when it comes to the price of options, which could be worthless if the price of the underlying asset falls or rises above a particular price. The most immediate benefit of knowing the rate of price change for a Forex spot trader is knowing whether a trend is either beginning or ending. When volatility increases, the price is on the move. When volatility is low, things are slowing down.
Some examples of volatility based indicators include volatility channels like Bollinger Bands and Keltner Channels, the Parabolic SAR and the Average True Range (ATR).
How do Volatility Based Indicators Work?
As volatility based indicators measure the frequency of price change, they make excellent tools for identifying when trends are underway and when they are ending. Bollinger Bands and Keltner Channels are two volatility based indicators that create “envelopes” around the price action on a chart and make it very easy to visually identify the volatility at any given time.
Bollinger Bands on the EUR/USD pair
When the bands get very close together, volatility is very low. When the upper and lower bands of the bands or channels get far apart, volatility is high. These volatility channel indicators attempt to identify what is normal for a market so you can identify the price when it reaches into the abnormal range.
These indicators use something called a standard deviation to measure this. Bollinger Bands and Keltner Channels have as one of their parameters the multiple by which the standard deviation is multiplied. This allows you to increase or decrease the envelopes to fit your risk appetite or trading style.
The Parabolic SAR is another volatility based indicator. It stands for “Parabolic Stop and Reverse” and is designed to identify desirable points of entry and exit. The output of the Parabolic SAR indicator is a dot for each time period.
The Parabolic SAR attempts to calculate the likelihood of where the price will go. The price is most likely to not reach beyond the arc defined by the dots. If the price does reach beyond that arc, it is a trend termination signal. That is not to say that the trend is ending, but it should be taken as a trend termination signal to be interpreted in the light of other indicators or methods—such as support/resistance, RSI and so on.
It should also be noted that the Parabolic SAR is designed to only work in trends. If there is no trend happening, as in a ranging market, the Parabolic SAR is not useful. Always verify a trending market with another indicator, such as the Average Directional Index (ADX) or the MACD (Moving Average Convergence/Divergence).
The Average True Range is a simple indicator compared to the others mentioned. It is simply a measure of the range in price, usually over the last 14 periods.
Are Volatility Based Indicators Useful or Not?
Volatility based indicators are useful for helping to identify points of trend termination. When the dots of a Parabolic SAR cross from above price to below price or vice versa, this is a trend termination signal. When price crosses the bands of the Bollinger Bands or Keltner Channels, it is also a sign that a trend may be ending. When the Bollinger Bands or Keltner channels narrow significantly thereafter, it is an additional sign that the trend is getting bogged down.
Bollinger Bands and Keltner Channels on the USD/CAD pair
When the ATR is high, you can interpret it as a trend termination signal as it means the price is no longer strongly pushing in one direction but is veering all over the place. You should verify with other indicators that a trend was actually in place, however.
Volatility based indicators give you more insight into price over time than just looking at the price at any given moment. By calculating the probability that price will stay within a certain arc or envelope, these indicators are powerful tools to help you identify when the price is doing something you should take notice of.
Low volatility signals a slowdown in price movement. In the case of a trend, this is a sign that the trend may be ending. By combining volatility based indicators with other methods of technical analysis like support & resistance, relative strength index and moving averages, volatility indicators give you an extra level of confidence in what the market will do.
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