The volatility technical indicator is helpful in seeing potential market reversals. This guide explains what it is and how to recognize trends with the help of example charts.
What Is Volatility?
The volatility indicator, based on the true range of price, is based on the following 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.
Effect of Strong Trends on Volatility
This chart of the 5,000 ounce silver futures contract illustrates the point that strong trends might have low volatility.
As the price in silver futures was increasing, the volatility was steadily decreasing. The change in trend was characterized by increased volatility.
Increased Volatility and Price Bottoms
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.
This chart of the S&P 500 E-mini futures contract shows an example of how bottoms can be marked by increases in volatility.
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How Is Volatility Calculated?
Volatility can be calculated by comparing current or expected returns against the stock or market’s mean or average. It typically represents a large positive or negative change.
It’s possible to report daily, weekly, monthly, or yearly volatility. This can be calculated using variance and standard deviation, with standard deviation being the square root of variance.
A similar tool to the volatility indicator is the VIX and VXN indexes that measure the implied volatility of CBOE index options.
Learn more about technical analysis charting concepts and strategies, including:
- Market Thrust
- Accumulative Swing Index
- Mass Index
- Herrick Payoff Index
- Directional Movement Index
- Commodity Channel Index
- Commodity Select Index
- Swing Index
- Stochastic RSI
- Ulcer Index