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In simple terms, volatility is the price fluctuation of a trading object. Absolute volatility does not exist, so it must always be set in relation to a period under consideration. If price fluctuations are high during the period under review, this is called high volatility. The opposite would be low volatility.
Traders need volatility
It is characteristic of the typical trader that, depending on his trading system, he only holds a position in the market for a short time. Traders want a short holding period to keep the risk low. The holding period can be very variable. For example, this could be seconds or even days. For traders, volatility is one of the most important signal filters, since without volatility, no sufficient price change occurs. Without sufficient volatility, the trading range is too small to reach the break-even point. Finally, the trader must overcome the spread between the buy and sell price, and also cover his trading costs.
Sudden volatility changes the market
Volatility should not be confused with the price trend. On the contrary, volatility always accompanies the price trend. If a market is in a trend, there is high or low volatility within the trend.
If you study the volatility within the price trend, you will notice special features. In most cases, low volatility leads to a continuation of the trend. If volatility occurs within a trend, then it is a sign of new emotions. The emotions are always associated with fear and greed of varying degrees. That is why high volatility is particularly noticeable in a trend, because the result can only mean two things. Either the trend accelerates again and the steepness of the trend increases, or the trend reverses and the market corrects. However, the reversal does not have to mean the end of the trend, often only the trend stability is tested by a correction.
Figure 1 shows different Price formations that can occur under high volatility. The blue lines and arrows in the picture represent the dynamics of the market movement.
Chaikin volatility has been chosen as the lower indicator. This indicator has a particularly simple structure. To calculate it, a moving average is formed from the difference between high and low. A Rate-of-Change (ROC) is then formed from this. The result is a momentum indicator of volatility. If the chaikin volatility is above the zero line, the price fluctuation is high. However, the indicator does not show the direction of the price.
Volatility means risk and profit at the same time
Volatility develops due to changes in the opinions of market participants. This is caused by economic news, technical signals and other news. If sudden volatility occurs in a price movement, a change in rhythm usually occurs. This pattern of behavior occurs regularly during breakouts from trading ranges.
There are four low volatility situations in Figure 2. Here the Bollinger Band is a good indicator. For all Bollinger bands, the fluctuation range of the prices is calculated as a function of the standard deviation. If the Bollinger band contracts, there is a reduction in volatility.
When breakouts from trading ranges occur, the reduction in volatility is first, an important feature for the quality of the breakout. It shows how much market participants have become accustomed to the price level before the breakout. It is a calming of the market and a gathering of strength. After the breakout, volatility increases dynamically. In the Bollinger Bands, this is shown by the bands spreading.
Implied volatility of the VDAX
In contrast to the typical volatility indicators of an analysis software, there is a volatility DAX (=VDAX) calculated by the Frankfurt Stock Exchange. It shows the expected fluctuation range of the DAX for the next 30 days. The VDAX is thus future-oriented, while the other indicators represent historical volatility.
Figure 3 shows that it is also possible to conduct a technical analysis with the VDAX. The upper part of Figure 3 shows the VDAX. Within the VDAX, trend line breaks are shown. The VDAX functions in reverse to the DAX. This means that if the VDAX rises, then fear in the market will increase. This is then transmitted when DAX shares are sold. If the VDAX falls, the fear of market participants is reduced. Accordingly, more buyers will appear in the markets.
In the lower part of Figure 3, the DAX is shown with a line chart. The drawn arrows show the inverted trading signals from the DAX. Not all trading signals are successful. This will never happen on the stock exchange. But sometimes the VDAX is very fast and even gives a signal prematurely. Overall, the VDAX is a good confirmation indicator. If you see a trend line break within the DAX, then it is worth looking at the VDAX. If there is a reverse pattern there, then the trend line break of the DAX has a strong effect.
The most important volatility indicators
There are a variety of volatility indicators. In daily practice, the trader should focus on only one indicator. It is better to know one type of indicator well than several superficially. Each of the mentioned indicators has its advantages and can be adapted to a trading system by slight modifications.
Average True Range (ATR)
Chaikin Volatility (CV)
Historical volatility (HV)
The order of the volatility indicators is alphabetical and without evaluation.
The greatest opportunities through volatility
Volatility is a key element for profitable trading. High profits are possible if you find a very low volatility and speculate that this will be followed by dynamic movement. The second great profit situation is when you find a market reversal from a disproportionately high volatility.
In both cases, volatility is not the signal for a long or short entry. However, it does indicate the market environment in which there is an exceptionally good risk/reward ratio.