A change in volatility implies a change in the expected price range yet to come. A volatile security offers a wide range of possible outcomes. A nonvolatile security delivers a narrower and thus more predictable range of outcomes. The main reason to keep an eye on volatility is to adjust your profit targets and your stop-loss to reflect the changing probability of gain or loss.
Volatility is a concept that can easily slip through your fingers if you aren’t careful. Just about everybody uses the word volatility incorrectly from a statistician’s viewpoint — and even statisticians squabble over definitions. To the mathematically inclined trader, volatility usually refers to the standard deviation of price changes. Standard deviation isn’t the only measure of volatility, but it suffices for most technical analysis purposes. In general usage, volatility means variance.
Variance is a statistical concept that measures the distance of each bar between the high and low from the mean (such as a moving average). You calculate variance by taking the difference between the high or low from the average, squaring each result (eliminating the minus signs), adding them up, and dividing by the number of data points. Squaring magnifies wildly aberrant prices, so the bigger the variation from the average and the more instances of such big variations in any one series, the higher the volatility.
Traders don’t use variance as a stand-alone measure or indicator, and it’s not offered in most charting packages. Why? Because variance isn’t directly useful as a separate measure from the standard deviation, which is essentially the square root of variance. Don’t panic at the thought of square root or any other statistical measure in technical analysis. Your software will supply the indicators that incorporate variance, and you don’t have to know how to calculate the indicators in order to use them effectively.
Time frame is everything. How you perceive volatility depends entirely on the time frame you’re looking at. Failure to specify a specific time frame is why you see so many conflicting generalizations about volatility. The period over which you measure volatility has a direct effect on how you think about volatility and, therefore, what kind of a trader you are. Your trading style isn’t only a function of what indicators you like, but also of how you perceive risk. Two traders can use the same indicators but get different results because they manage the trade differently by looking at volatility differently (scaling in and out, choosing a stop-loss level, and so on).
In the following figure, your eye tells you that the low-variance prices on the left side of the chart are less volatile and therefore less risky to trade than the high-variance prices on the right side of the chart, even when the high-variance prices are in a trending mode. And that’s the point about volatility — it describes the level of risk. High variance means high risk.
Degrees of volatility.How volatility arises
Think of volatility in terms of crowd sentiment. Volatility rises when traders get excited about a new move. They anticipate taking the price to new highs or lows, which arouses greed in bulls putting on new positions and fear in bears, who scramble to get out of the way in a cascade of stop losses. The start of a new move is when you get higher highs (or lower lows). Volatility tends to be abnormally low just before a turning point and abnormally high just as the price is taking off in the first big thrust of a new trend. It’s also, however, a sad fact of trading life that sometimes volatility is high or low for no price-related reason you can find.High volatility means trading is riskier but has more profit potential, while low volatility means less immediate risk.
Volatility isn’t inherently good or bad. Stability of volatility over time is a good thing because it allows you to estimate maximum potential gains and losses with greater accuracy. Every security has its own volatility norm that changes over time as the fundamentals and trader population changes. Sometimes you can impute a “personality” to a security that is really a reflection of the collective risk appetite of its traders.Low volatility with trending
Refer to the preceding figure. As the price series begins, you instantly see an upward trend. Your ability to see the trend is due in part to the orderliness of the move. You see the trend, not variations away from it.A trending security with low volatility offers the best trade because it has a high probability of giving you a profit and low probability of delivering a loss. It’s also easier on the nerves. Here’s why low volatility means the best trade:
- You can project the price range of a low-volatility trending security into the future with more confidence than a high-volatility security.
- You generally hold a low-volatility trending security for a longer period of time, reducing trading costs such as brokerage commissions.
Low volatility without trending
A security that’s range-trading sideways with little variation from one day to the next is simply untradeable in that time frame. You have no basis on which to form an expectation of a gain, and without an expectation of gain, you shouldn’t trade it. You can reduce the time frame (from one day to one hour, for example) to make visible and tradeable the minor peaks and troughs.If a price is trading sideways without directional bias but the high-low range of the bars contracts or widens, now you’re cooking with gas. Range contraction and expansion are powerful forecasting tools of an upcoming breakout. You can start planning the trade. In the figure, every bar is the same height except the ones in the circle, which are narrowing. The drop in high-low range and therefore in volatility often precedes a breakout, although you don’t know in advance in which direction unless you also have a reliable pattern, including candlesticks.
High volatility with trending
You may think that the degree of volatility doesn’t matter when your security is trending, but an increase in volatility automatically increases the risk of loss. You may start fiddling with your indicators to adapt them to current conditions. Tinkering with the parameters of indicators when you have a live trade in progress is always a mistake. A better response to rising volatility is to recalculate potential gain against potential loss.
High volatility without trending
When a security is range-trading, it’s called a trader’s nightmare. When it’s range-trading with high volatility, it’s a horrible nightmare. The right section of the price series in the figure shows this. In this situation, the range is so wide you can’t identify a breakout; you see spiky one- and two-day reversals as bulls and bears slug it out, making it hard to find entries or to set systematic stops.The solution to high volatility in a nontrending case is to stop trading the security or to narrow the time frame down to an intraday time frame. Often you can find tradeable swings within 15-minute or 60-minute bars that don’t exist on the daily chart.