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How to Measure Volatility

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Volatility is a mathematical term that is used to determine the expected returns from a portfolio. Statistically, volatility is used to understand the severity of how much a price can move from its average levels.
Volatility is often measured by a standard deviation. Standard deviation is nothing but the amount of deviation from the expected returns or the average price of a security. Volatility is mostly used to measure the returns and is represented in percentage terms.
When you measure volatility you are simply measure how far high or low the price of the security can deviate from its average or mean price. Besides being used in portfolio analysis and how risky an investment can be, volatility is also one of the factors used in technical analysis.

1.Volatility in technical analysis

In technical analysis, volatility is used to understand the expected movement of price from its median or average price levels. This tells you how much risk or how less risky the price of an asset can be.
There are a number of technical indicators that make use of volatility. For example, the most commonly used volatility indicators are Bollinger bands. This technical indicator was developed by John Bollinger.
It consists of a set of bands based on a 20-period moving average. The upper and lower limits indicate how much fluctuations can be expected. When the volatility rises, the band tends to expand and move in the opposite direction. This leads to an expansion of the frequency band, which is called a rise in volatility. Conversely, if the frequency band shrinks, the Bollinger Bands will also shrink, indicating that the volatility is decreasing.
(Bollinger bands for measuring volatility)
For the most part, traders and especially day traders make use of volatility. Without volatility, there are no profits to be made.

2.Why does volatility mater for traders?

When a price moves a certain amount from its expected mean or average price, it indicates that the price of the security can move quite a bit during the course of the trading period.
This allows traders to tune their trading systems in order to make significant profits.
On the same side, volatility can also be risky. It can potentially erode the profits one can make while at the same time, volatility can increase the losses too.
Volatility usually comes when the markets fail to discount some news. In general scenario, you can see higher volatility in the markets when there is a big news release. In some cases, Black swan events that are totally not discounted by the price already can create huge volatile moves in the markets.
Volatility can be measured across different time frames and markets. Some markets such as commodities tend to be very volatile. For example, if you look at the crypto currency markets, there is a lot of volatility that is not so common with other types of markets such as stocks or even forex.

3.Measuring volatility using technical indicators

You can measure volatility by using a number of technical indicators. While we briefly covered Bollinger bands, you can also make use of other technical indicators such as the Average True Range.
The average true range of the ATR is a simple technical indicator that makes use of price’s high and low. The ATR then smooths out the day to day deviation from the price’s high and low and gives an average range of the price.
(Average True Range Indicator)
The ATR is commonly used by traders to set their stops or even target profit levels. The ATR tells traders how far the price has moved over an average period of time. This in turn can give traders a good idea of what to expect.
One thing to remember is that the average true range indicator is basically lagging in nature. It takes into account the average range of the price over the past n-periods. As a result, the ATR doesn’t give you the details in real time.
Still, volatility tends to last over long periods of time. Thus, when the ATR is high, you can expect to see a significant amount of volatility still being displayed in the markets.
In conclusion, volatility is a measure of the standard deviation of price from its mean (think, moving averages). Volatility is good for day traders as it allows them to make a profit over time. Without volatility, the markets would practically be moving sideways.
Using the two technical indicators that we mentioned; namely the average true range and the Bollinger bands indicator, traders can measure volatility with decent accuracy.
(by allfxbrokers)


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