How Volatility Can Help Your Trading

Hundreds of indicators are available to help traders analyze price action. Moving averages, stochastics, MACD, RSI and other less well-known indicators help identify the trend or warn of a possible trend reversal. While the details of how to calculate each indicator varies, they are all using closing prices as their primary input. A moving average sums the closing prices while the stochastics formula places the closing price within context of the recent price action by including the recent high and low prices in its calculation. All of these indicators have been developed to find a tradable edge that can produce profits. The idea seems to be some formula involving closing prices will provide an indication of what the future holds.

Many of these indicators do have some value but traders find it difficult to beat the market without an information edge. An information edge can be a piece of data that is available but ignored by most traders. Since a majority of the standard indicators rely on closing prices, traders may want to consider looking beyond that piece of data for an information edge. One area that seems useful for finding an edge is in volatility indicators.

Options traders spend a great deal of effort to capture volatility data. What may be the most famous volatility indicator, the VIX Index, is based on the implied volatility of various options contracts. Finding implied volatility requires analysts to solve a complex pricing formula and it is, in total honesty, beyond the capability of most individual investors since it requires real-time access to options pricing data. This data is generally included only in high-priced data services available only to institutional investors.

Availability of data and complex calculations are only two of the factors that limit the usefulness of VIX. This indicator actually only offers information about the S&P 500. Many traders do extrapolate VIX to the broad market or to individual stocks but this can be an expensive mistake.

VIX is based on the implied volatility of S&P 500 options contracts. When VIX is high, traders are willing pay a premium for the options because they believe the options will provide protection against further losses. This generally leads to increases in VIX as the value of the S&P 500 falls. That relationship has led to the VIX index being called the “fear index” since high readings of VIX are associated with high levels of fear and low levels of VIX are seen in rising markets when fear is low.

During a market selloff, when VIX is high, most stocks will be falling. Some traders therefore use VIX to time entries into individual stocks. Unfortunately, VIX isn’t telling us anything individual stocks and in a recovery, it’s likely some stocks will lead while other will lag or even continue falling. Relying on VIX ignores this reality and can lead traders to buy stocks that are not participating in a market rally.

There are other indicators that measure volatility and these indicators can be applied to individual stocks.

One volatility indicator is simply the range of the price action. The range is defined as the difference between the highest and lowest prices for the day (or week, or month or other time frame). A chart of Apple (Nasdaq: AAPL) is shown below with the range indicator shown at the bottom of the chart.

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We can see in the chart that the range behaves in a way that is like the VIX index, the indicator rises as prices are falling and peaks as prices bottom. This behavior explains one of the reasons traders should pay attention to volatility. High volatility can help identify short-term bottoms in price.

The range ignores gaps, sharp increases or decreases in price that occur at the open. Gaps are marked with arrows in the next chart and another indicator, the True Range is added to the bottom of the chart.

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The True Range closely approximates the range but is a more accurate calculation of the day’s trading activity. The True range is the greater of (1) today’s high minus today’s low, (2) the absolute value of today’s  high minus yesterday’s close which captures the value of a gap up or (3) the absolute value of today’s low minus yesterday’s close which captures the magnitude of a gap down.

Although True Range and Range will generally be similar, traders should use the True Range to account for gaps.

We can also take averages of the range or True Range. The Average True Range (ATR) is a popular indicator available at web sites including StocksCharts.com or TradingView.com. ATR is shown in the next chart.

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This is a 14-day ATR, using the previous 14 True Range values in its calculation. Other values can be used in the calculation besides 14 and traders should always use the parameters they find to be most useful.

In the chart, ATR shows a rhythm or a cycle in its pattern. Many traders find volatility tends to move in this pattern, alternating between high and low readings. This is not a cycle like we find in physics with a predictable length and steady changes in height. Traders use the word cycle differently than physicists. ATR forms a cycle in the sense that it moves form high to low and vice versa over time, although the time varies and the height of the peaks and troughs also vary.

The cycle seen in the ATR can be used to develop a trading strategy. When ATR is low, prices are most likely in a trading range. For a trader, capital is limited. Buying a stock in a trading range ties up a valuable resource, trading capital, and prevents the trader from pursuing profits in stocks that are moving. A glance at the ATR can help identify whether or a not a stock is in a trading range or not. When the ATR is rising or falling, the stock price is most likely moving and could be capable of delivering profits quickly.

Shorter-term traders could consider using a short-term ATR. By using 7 or 10 days in the calculation, the indicator will be more responsive to changes in volatility and could help traders enter positions earlier. Longer-term traders can use weekly charts, calculating ATR with weekly data to slow down the trading signals and potentially trade only when the biggest price moves are starting.

It is important to remember that ATR is not a directional indicator. Rising values mean volatility is rising and prices are usually falling as this happens but traders need to confirm the price action with chart analysis or the use of other indicators. ATR, or other volatility indicators, are best used as one input to a trading strategy and should be relied upon to provide buy or sell signals as a standalone trading system.

There are other volatility indicators in addition to range, True Range and ATR. Many successful traders use volatility to supplement their analysis of the price action to increase the likelihood of finding trades that move quickly. They often incorporate volatility into their strategy, combining volatility and a price-based indicator. For example, a trader might require the ATR to be less than its 26-week moving average indicating the stock is in a trading range and then buy when the 5-day moving average crosses above the 20-day moving average indicates a possible up trend is beginning. There are countless variations of this idea and you may find one of the variations fits your trading style and could increase your profitability.