Tips on Technicals - Volatility (Historical)
| Indicator type: |
Statistical |
| Used to: |
Quantify risk and market noise |
| Markets: |
All cash, futures and options |
| Works Best: |
Liquid markets in all time frames |
| Formula: |
The formula for volatility is calculated as the standard deviation of the log of relative prices over the past n-days. It is an annualized result and is consistent with the view that securities prices are lognormally distributed.
| volatility =
where: |
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The constant 252 represents the number of trading days in the year |
| Parameters: |
Volatility is usually based on a 20-day annualized formula (n=20). For intraday volatility, both the "n" value and constant value representing trading days must be modified. For example, if hourly volatility is needed, "n" would mean 20 hours and the constant 252 would be multiplied by the number of trading hours per day to get trading hours per year. |
| Theory: |
Historical volatility is the measure of how prices vary around an average price. The more the market moves, the greater the volatility and the greater the risk. A market that is trending smoothly and at a constant rate, has a higher volatility than a market that is moving sideways with a "normal" trading range. ("Normal" refers to the width of the trading range being the same as it has been historically for that specific market). Of course, if the trading range for the sideways market is wide, volatility will be higher. |
| Interpretation: |
When a market has been trading sideways and volatility begins to increase, a breakout from that range, either higher or lower, is likely. This indicates buyers and sellers becoming more active. Eventually, one side should prevail. For all markets, a decrease in volatility also indicates a likely breakout. This is because buyers and sellers have decreased their activity because neither side is completely confident of their opinions.
Volatility does not predict the direction that prices will move. It can, however, help in determining if other technical patterns are valid. For example, if a declining market trades through its resisting trend line it would ordinarily indicate an upside change in trend. If the market has a high volatility, the breakout would need to be more significant to be valid than one in a low volatility market. This is because false breakouts and trading "noise" are likely in the high volatility market.
For options trading, long positions are attractive when volatility is low. Conversely, short positions are attractive when volatilities are high. Each market has its own definition of what are the high and low volatilities.
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Volatility can help forecast both breakouts from technical patterns and profitable entry points for options trading. Note that the British Pound/ US Dollar rate began major and minor moves just after periods of low volatility (local dips in volatility). Options traders use low volatility to buy options and high volatility to sell them. Note that options trading is much more complex than this but volatility is one of its key indicators.
