Volatility Analysis
When trading in the stock market we should not only look at whether the market is trending or consolidating but we should also deal with volatility.
Thus, it is important for the traders to understand the volatility indicators which can help them to trade more effectively.
Volatile periods in the stock markets can create big swings in the markets which can make it difficult for the traders to trade.
Extreme volatility can be seen in the market when certain news comes which are extreme.
High Volatility can be seen when the market is trending and low volatility occurs during the consolidation phase of the market.
What Is Volatility?
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.
In the securities markets, volatility is often associated with big swings in either direction. For example, when the stock market rises and falls more than one percent over a sustained period of time, it is called a "volatile" market. An asset's volatility is a key factor when pricing options contracts.
Types of Volatility
- Stock Volatility
Investors have developed a measurement of stock volatility called beta. It tells you how well the stock price is correlated with the Standard & Poor’s 500 Index. If it moves perfectly along with the index, the beta will be 1.0. Stocks with betas that are higher than 1.0 are more volatile than the S&P 500. Stocks with a beta less than 1.0 are not as volatile.
Economists developed this measurement because the prices of some stocks are highly volatile.6 That unpredictability makes that stock a more risky investment. As a result, investors want a higher return for the increased uncertainty.
- Historical Volatility
Historical volatility is how much volatility a stock has had over the past 12 months. If the stock price varied widely in the past year, it is more volatile and riskier. It becomes less attractive than a less volatile stock. You might have to hold onto it for a long time before the price returns to where you can sell it for a profit. Of course, if you study the chart and can tell it's at a low point, you might get lucky and be able to sell it when it gets high again.
That's called timing the market and it works great when it works. Unfortunately, with a highly volatile stock, it could also go much lower for a long time before it goes up again. You just don't know because it's unpredictable.
- Implied Volatility
Implied volatility describes how much volatility that options traders think the stock will have in the future. You can tell what the implied volatility of a stock is by looking at how much the futures options prices vary. If the options prices start to rise, that means implied volatility is increasing, all other things being equal.
- Market Volatility
Market volatility is the velocity of price changes for any market. That includes commodities and the stock market. Increased volatility of the stock market is usually a sign that a market top or market bottom is at hand. There is a lot of uncertainty. Bullish traders bid up prices on a good news day, while bearish traders and short-sellers drive prices down on bad news.
The VIX® uses stock index option prices. The Chicago Board Options Exchange created it in 1993. It gauges investor sentiment.
The VIX® is also called the fear index. When the VIX® is high, stock prices fall. Often, oil prices also drop as investors worry that global growth will slow. Traders searching for a safe haven bid up gold and Treasury notes. That sends interest rates down.
Understanding Volatility
Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, and tends to be more steady.
One way to measure an asset's variation is to quantify the daily returns (percent move on a daily basis) of the asset. Historical volatility is based on historical prices and represents the degree of variability in the returns of an asset. This number is without a unit and is expressed as a percentage.
While variance captures the dispersion of returns around the mean of an asset in general, volatility is a measure of that variance bounded by a specific period of time. Thus, we can report daily volatility, weekly, monthly, or annualized volatility.
Calculating Volatility
The simplest approach to determine the volatility of a security is to calculate the standard deviation of its prices over a period of time.
This can be done by using the following steps...
- Gather the security’s past prices.
- Calculate the average price (mean) of the security’s past prices.
- Determine the difference between each price in the set and the average price.
- Square the differences from the previous step.
- Sum the squared differences.
- Divide the squared differences by the total number of prices in the set (find variance).
- Calculate the square root of the number obtained in the previous step.
Sample Calculation
You want to find out the volatility of the stock of ABC Corp. for the past four days. The stock prices are given below......
Day 1 – $10
Day 2 – $12
Day 3 – $9
Day 4 – $14
To calculate the volatility of the prices, we need to Find the average price
$10 + $12 + $9 + $14 / 4 = $11.25
Calculate the difference between each price and the average price
Day 1: 10 – 11.25 = -1.25
Day 2: 12 – 11.25 = 0.75
Day 3: 9 – 11.25 = -2.25
Day 4: 14 – 11.25 = 2.75
Square the difference from the previous step
Day 1: (-1.25)2 = 1.56
Day 2: (0.75)2 = 0.56
Day 3: (-2.25)2 = 5.06
Day 4: (2.75)2 = 7.56
Sum the squared differences
1.56 + 0.56 + 5.06 + 7.56 = 14.75
Find the variance:
Variance = 14.75 / 4 = 3.69
Find the standard deviation
Standard deviation = 1.92 (square root of 3.69)
The standard deviation indicates that the stock price of ABC Corp. usually deviates from its average stock price by $1.92.
Volatility Indicators that Traders should know
Volatility trading indicators
As we have discussed, the average true range is a particularly effective tool for tracking how much an asset is moving, on average, for each price bar.
Historical volatility also measures price action. This is a technical indicator that is shown below on the EUR/USD chart. Implied volatility anticipates what could happen in the future. For example, historical volatility may be low, yet we know that if the US Federal Reserve or the Bank of England releases an interest rate announcement, this will cause increased price movement and volatility in the forex market. Implied volatility is derived from the options market, where put and call options are bought and sold.
The Relative Volatility Index (RVI) is another indicator that analyses the direction and volatility of price. It is the bottom indicator shown on the EUR/USD chart below. When the indicator is above a level of 50, this means that volatility is on the upside. When the indicator is below 50, this means that volatility is on the downside. Therefore, if a buy signal occurs and the indicator is above or passing above 50, this helps to confirm the buy signal. If a sell signal occurs and the indicator is below or passing below 50, this helps to confirm the sell signal. It is not reliable as an indicator when only used by itself, but can be used to confirm entries in conjunction with other strategies.
Volatility Indicators help in gauging the periods of high and low volatility in the particular stocks or market as a whole.
The big swings created by the volatility can provide good trading opportunities to the traders. there some other useful indicators that help too.
- 1. Donchian Channel
Donchian Channels is a popular volatility indicator determining volatility in the market prices.
This indicator is created by three lines that are generated by moving average calculations.
It consists of three bands: upper and lower bands around a median band.
The upper band shows the highest price of security whereas the lower band shows the lowest price of a security over a specific period, usually 4 weeks.
The area between the upper and lower bands is the Donchian Channel.
- 2. Bollinger Bands
Bollinger Bands consist of 3 bands: the upper, lower and middle bands.
The middle band is the 20 days or bars moving average, the upper band is +2 Standard Deviation and the lower band is the -2 Standard Deviation of the middle band.
When the volatility in the market increases then these bands expand, and when the volatility decreases then these bands contract.
Traders can trade with the Bollinger bands when the prices break out from either side of the upper or lower bands after the low volatility or consolidation phase.
- 2. Keltner Channel
Keltner Channels is a volatility-based indicator that is placed on either side of the stock’s price and helps in determining the direction of a trend.
The Keltner channel uses the average-true range (ATR) with breaks above or below the top and bottom barriers that signals a continuation in the trend.
The middle line is an exponential moving average (EMA) of the price. The upper band is usually set two times the ATR above the EMA, and the lower band is set two times the ATR below the EMA.
These bands generally expand and contract as volatility which is measured by ATR expands and contracts.
- 4. Average True Range (ATR)
The ATR measures the true range of a particular number of price bars, usually 14.
ATR is a pure volatility measure that does not necessarily indicate a trend. Sometimes volatile price movement can occur inside a choppy market during an important news event.
The best way of using the ATR is as an indication of the change in the market’s nature.
A rise in ATR indicates higher trading ranges and thus an increase in volatility. Whereas low readings from the ATR indicates periods of quiet or uneventful trading.