Volatility is the measurement of how much an asset changes in value over a given period of time. If a trader buys an asset, they expect that asset to increase in value during the course of that trade. Conversely, if a trader sells an asset, they expect it to decrease in value during the course of the trade. The more its value changes, the higher its volatility. If the price of an asset has a high volatility, there is more risk associated with trading it, but greater potential for profits. If an asset has a low volatility, there is a lower risk trading it, but less profit potential. Market volatility can also be referred to as price volatility, or trading volatility.
As a trader, you are always looking for ways to increase profit. Thus, you will seek out the most volatile assets which give higher potential for profit.
Measuring market volatility
In trading, volatility is measured using certain indicators including moving averages, Bollinger bands and average true range (ATR). Each of these indicators can be used slightly differently to measure the volatility of an asset and more importantly, interpret this data in a different format.
Moving averages are displayed on the actual price chart and the distance between the moving average and the price shows the volatility of the asset. The further away the price is from the moving average, the higher the volatility of the asset.
The image below shows the moving average line far away from the price above it, demonstrating that this asset has a high volatility.
The next image demonstrates an asset of low volatility; the moving average is close to the current price.
Another very common tool used to measure price volatility is the Bollinger bands indicator. Bollinger bands display the volatility in a slightly different way. Several lines are applied to the price action which squeeze together when volatility is low and expand when it increases. An asset with expanded bands is in a high volatility state.
The image below demonstrates what Bollinger bands look like on a price chart when volatility is high.
The image below demonstrates what the bands look like when a pair has low volatility.
Average true range (ATR)
Another common measurement of market volatility is the ATR indicator. This tool measures the volatility and gives an actual value. So rather than observing the price in relation to a tool, such as a moving average or Bollinger bands, the ATR gives a value – the higher the value, the higher the volatility.
The ATR also shows whether the volatility is increasing or decreasing, as well as what the volatility is at a given time.
The image below shows that the asset not only has a high range, but that the range has also been increasing over time, indicating increasing volatility.
- High range
- Range increasing over time
The image below shows an asset with a low range which is decreasing, indicating lower volatility.
- Low range
- Range decreasing over time
It is important to note that the ATR indicator does not give the direction of the trend, simply whether the volatility of that asset is increasing or decreasing. When the ATR line goes up, the volatility has gone up.
How to use volatility
If the volatility is low and decreasing, it is much safer to avoid placing any trades on that pair as the probability of a profitable move occurring is greatly reduced.
In contrast to this, when anticipating large moves, particularly breakouts, it is important to trade in times when volatility is increasing. When volatility is high, the probability of a large move occurring is higher and traders have a greater chance of making money.
So far, you have learned that ...
- ... market volatility is a measurement of how much the value of an asset changes.
- ... the higher the volatility, the greater the profit potential for that asset.
- ... we can use various indicators to tell us the volatility of a pair at any given time.
- ... if a moving average is far away from the price, this indicates high volatility and if the moving average is close to the price, this indicates low volatility.
- ... if the Bollinger bands have expanded apart this indicates high volatility and if the Bollinger bands contract this indicates low volatility.
- ... a rising ART value indicates high volatility and a decreasing ATR value indicates low volatility.