Do Volatility Indicators Do What Their Name Suggests? An Expert Explains

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The Volatility technical indicator is helpful in seeing potential market reversals. This Volatility indicator based on the true range of price is based on the premise:

  • Strong trends upward are marked by decreases in volatility.
  • Strong trends downward show a general increase in volatility.
  • Reversals in trend usually occur when volatility increases.

The chart below of the 5,000 ounce Silver futures contract illustrates the first point, that strong trends might have low volatility:

 
Volatility increases as prices fall, volatility decreases as prices rise

 

As the price in silver futures was increasing, the volatility was steadily decreasing. The change in trend was characterized by increased volatility.

Bottom Reversals

When prices bottom, they are usually accompanied by increased volatility. An increase in the Volatility indicator after a recent decline, could signal that the price is bottoming.

A trader might exit or reduce the size of short positions during this time of increased volatility at a bottom. Other indicators would be used to determine when a trader might enter a long position.

The chart below of the S&P 500 Emini Futures contract shows an example of how bottoms can be marked by increases in volatility:

Increases in volatility can often mean price bottoming

Due to the general inverse relationship of volatility and price, the Volatility indicator might be useful in determining strong trends and potential price bottoms. Another similar tool is the VIX and VXN indexes that measure the implied volatility of CBOE index options (see: VIX & VXN Volatility Indices).

How to Get Started Trading

If you are interested in trading, have a look at our reviews of these regulated brokers available in to learn which charting tools they offer:

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 73.90%-89.00% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Further Reading

Learn more about technical analysis indicators, charting concepts and strategies including Volatility, Momentum, Triple Exponential Average (TRIX), Fibonacci Time Extensions, and the McClellan Oscillator.

Also see our guide to understanding the basics of reading candlestick charts and option trading strategies.

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