Average True Range (ATR), Bollinger Bands, and Chaikin Volatility Indicator (CVI) can help options traders identify high volatile stocks. Throw in the ImpVolatility indicator and see how well all these indicators correlate.
A strong wind forecast is enough to send most of us indoors. Not surfers, though. For them, it’s a different story—a surfer lives for windy conditions. But it has to be the right kind of wind. There are plenty of factors that impact the quality of the surf—tide, type of wind, type of break, direction of wave. The right combination creates the perfect surf. Surfers long for those days—that’s when you’ll find them at the beach in swarms.
The relationship between surfers and surf quality can be compared to the relationship between option traders and volatility (“vol”). In a high-vol environment, options trading activity typically increases. It’s an option trader’s playing field.
All option traders know the ubiquitous Cboe Volatility Index (VIX). And that a high VIX generally indicates high vol. But VIX isn’t the only volatility indicator out there. Stock traders who rely on charts may also consider vol, but they approach it a little differently. Stock traders have more choices when it comes to vol indicators. So, can option traders use some of those studies to help analyze a stock’s options?
When vol starts heating up, it’s time to look for opportunities. If two or more indicators confirm high vol, the likelihood of seeing increased trading activity is higher, too. We’ll look at three popular vol indicators stock traders use that option traders could adopt into their trading decision-making rules.
Average True Range. J. Welles Wilder developed the average true range (ATR) indicator to measure volatility in commodities, although it’s widely used by stock traders as well. ATR looks at the difference between the current high and low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close. The method you might choose depends on whether the prevailing price bar is an outside day, gap, or inside day. For example, if the prevailing high is higher than the previous day’s high, and the prevailing low is lower than the previous day’s low, then you’d use the difference between the current high and low. If there’s a gap up or down, or if the prevailing close is within the high-low range of the previous day, then you’d use the absolute-value calculations. When using those absolute values, you can expect ATR to be lower for lower-priced stocks, and higher for higher-priced ones.
To calculate ATR, take the average of the price ranges. Typically, price ranges are averaged over 14-day periods. In other words, you go back 14 days, add up the true ranges, and divide by 14. Generally, when price moves strongly—such as before earnings—you might see large price ranges. When prices move within a trading range, meaning that movement is relatively flat, price ranges tend to be small.
You can use ATR to identify market changes. For example, if price has been trading within a range for a relatively long time, and then starts to show signs of breaking out, you may see ATR start to rise. On the other hand, if a volatile market starts to trend up or down, ATR could fall. You can see this in Figure 1. After a consolidation period where the average price range was low, price gapped up. Notice how ATR spiked and continued moving up. After trading activity slowed, even though the market continued to trend up, ATR moved lower.
FIGURE 1: PRICE RANGE, GAPS, AND VOLATILITY. The average true range (ATR) indicator picks up the pace when prices break out of a consolidation with a gap upward. ATR moved lower even though prices continued to trend up, suggesting price ranges were smaller and vol was drying up. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
Bollinger Bands®. Developed by John Bollinger, Bollinger Bands are popular and available in just about any charting software. They’re used to identify if prices might be high or low on a relative basis over a specific time frame. As the name suggests, they’re bands or envelopes that can be overlaid on price charts.
Bollinger Bands are calculated based on the distance of price from a moving average over a specified number of bars, typically 20. The bands are a fixed number of standard deviations above and below the moving average, usually two. Because the bands are based on standard deviations, they adapt to changing market conditions. Two standard deviations means that 95% of price movement will be within the bands. So, when price breaks out above or below the bands, think of it as out of the ordinary, which can mean an increase in vol.
When you apply Bollinger Bands, you’ll see three lines (Figure 2). The upper and lower bands represent standard deviations—usually two—above and below the moving average, which is the middle line.
In addition to vol, Bollinger Bands also indicate the direction of price. When price is at the higher band, it indicates that price is high. When price is at the lower band, it indicates that price is low.
The bands have a tendency to widen and narrow. When price volatility is high, the bands widen. And when it’s low, the bands tighten. But of course with the markets, anything is possible, including high vol during consolidations. So if you see wide bands moving sideways, it could mean choppy trading conditions ahead.
FIGURE 2: BOLLINGER BANDS, VOL, AND PRICE DIRECTION. The narrowing of the bands suggests volatility is low. When they widen, it may mean price movement is volatile. How price moves with respect to the upper or lower bands may indicate which direction prices are moving. Source: thinkorswim from TD Ameritrade. For illustrative purposes only.
Chaikin Volatility. The Chaikin volatility indicator (CVI), developed by Marc Chaikin, measures vol by looking at the difference between the high and low for each period or trading bar. When the range between the high and low is wide, it can mean higher vol. When the range is narrow, it can mean lower vol. This indicator calculates the percentage change in a moving average of a high versus a low price over a certain time frame, usually 10 bars. The objective is to look for sharp increases in vol. The indicator fluctuates around zero (see Figure 3). As its value increases, it suggests prices are changing fast, and within a wide range. In a word, it suggests greater volatility. When CVI decreases, it suggests prices are moving within a narrow range, or that the market is perhaps less volatile. Unlike the ATR, CVI doesn’t consider gaps in its calculation.
In Figure 3 you’ll see that the CVI creates clear peaks and troughs. Notice how the indicator ebbs and flows around the horizontal zero line. The movement is smooth, and you can clearly identify if the indicator is moving up or down.
FIGURE 3: CHAIKIN VOLATILITY INDICATOR. The indicator moves above and below the zero line smoothly. Source: thinkorswim from TD Ameritrade. For illustrative purposes only.
Why would option traders use these price chart indicators when they can use vol-specific indicators to make trading decisions? Generally, vol indicators reveal when options prices may be cheap or expensive. When vol is high, options prices might be expensive, and when vol is low, they may be cheap. But more to the point, what’s considered low or high vol? Even when vol looks high, it could go even higher. There’s no way to know with certainty. Indicators such as Bollinger Bands, ATR, and CVI look at past prices to indicate prevailing price action. So, what if you combine these indicators with something that looks more toward the future?
One choice is to use ImpVolatility (“Implied”) on your thinkorswim platform from TD Ameritrade. The indicator is mean-reverting, and looks at the last 52-week high/low range of a stock price to anticipate vol. Keep in mind that some stocks may be more volatile than others, which means vol will vary from one stock to another.
Let’s combine all these indicators—ATR, Bollinger Bands, CVI, and Implied—on one chart and see how they work together. In Figure 4, Bollinger Bands are overlaid on the price chart, while ATR, CVI, and Implied are in the lower studies chart.
FIGURE 4: WHERE IS VOL? Using ATR, Bollinger Bands, CVI, and ImpVolatility can help identify when vol is increasing or decreasing. Source: thinkorswim from TD Ameritrade. For illustrative purposes only.
As you can see, when Bollinger Bands narrow, these indicators would seem to agree that vol is low. Notice how Implied takes the lead and starts moving up. A few days later, ATR and CVI move higher. And when all three indicators start their upward move, Bollinger Bands start expanding, and price moves along the upper band. Then, Implied traditionally starts to move lower, while the other indicators might continue their move upward. It’s not until price starts to revert toward the midline of the Bollinger Bands that these indicators show a cooling down in vol. You’ll often see this scenario play out in the equity markets. After a consolidation period, stock traders rush to buy the stock on the first signs of an uptrend. After the initial rush, price may mean-revert, and vol cools down.
A few months later, Implied moves higher than the other indicators. Prices are “walking along” the lower Bollinger Band. All indicators show a high-vol environment. It’s fun to note that Implied tends to spike when prices are lower on a relative basis, possibly because stock traders tend to buy when prices fall, thus increasing a stock’s vol. The other indicators suggest price may continue moving up. When such scenarios occur, it’s worth heading over to the Analyze tab on your thinkorswim platform to review the option chains and look for premium-selling opportunities.
High vol is important for an option trader. The challenge is to find the stocks with high vol, which is where these indicators come in handy. You could use price chart indicators and vol-specific indicators as a scanning tool to help identify high-vol trades with relatively higher price ranges. You may even get an idea of the potential direction of price movement. The key is to have the patience to wait for the right conditions.
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Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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