In technical analysis, many traders start with trend and momentum indicators. But don’t forget volatility indicators, which track the magnitude of price movements.
Volatility, trend, and momentum are three distinct, yet integrated, ways to view price action
There are several types of indicators you can use to analyze each type
Bollinger Bands® and average true range indicators can help you better understand a stock’s volatility profile, at least enough to plot effective entries and exits
You’ve done all the fundamental legwork on a stock you’re looking to buy. You decide it’s time to pull the trigger. Now comes the tactical work. You look at the chart and see one of two things: Either the stock has been jumping wildly up and down as if it can’t decide on a clear direction, or the stock’s seemingly motionless as if it doesn’t want to move at all.
Now you’ll have a host of questions to answer: Should you jump in now? Is there a good entry point? If it’s moving, is it bound to exhaust itself and reverse? If it’s not moving, might it be coiling like a spring, preparing for a big and sudden jump?
The answers to these questions are coming from three angles folded into one. Breaking it down, you’re trying to get a sense of the stock’s trend, momentum, and volatility (or lack of it).
Here’s the thing: You don’t want to confuse the three—volatility, trend, and momentum—but you certainly don’t want to take one view over the others. Here’s an overview of each.
Trend is the overall direction of the stock. It’s either moving up, down, or sideways. The big caveat here is that there can be multiple and sometimes “contradictory” trends in the short, intermediate, and long term. There are numerous trend indicators out there. The most basic, perhaps, are moving averages. So if you’re new to trend following, start with those and work your way up.
Momentum refers to the strength behind a stock’s movement. No matter how energetically a stock can be moving, up or down, its momentum can still be either weak or strong. One popular indicator for gauging momentum is the relative strength indicator.
Volatility is a measure of a stock’s degree of variation in relation to an average price level or range of movement. In plain language, it’s a measure of the “jumpiness” of a stock’s price. Volatility can be a tricky matter, partially because the term itself has a bad rap—it’s frequently associated with stock market crashes.
Let’s address a few things about volatility:
Movement is movement, up or down. And there are technical tools on the thinkorswim® platform to help you identify volatility and avoid getting “shaken out” of a potential opportunity when it presents itself.
Bollinger Bands can help you observe volatility by watching price move in relation to a moving average, always at the center of the action, and two price thresholds on the upper and lower ranges of the price action (see figure 1).
FIGURE 1: BOLLINGER BANDS CONTRACTING AND EXPANDING. Notice how the period of low volatility and narrow bands dramatically expanded as price shot up (candlestick chart). When price closed above the second standard deviation (the upper red band), traders might have thought the asset to be overbought, after which price reverted to the mean (blue line). Also, notice how prices tend to bounce between the upper and lower bands, how the moving average reflects the short-term trend direction, and how the bands narrow as volatility decreases. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
The moving average, typically set to a 20-day simple moving average (SMA), helps you see what the average price is and which direction it’s trending. The surrounding bands, typically set to two standard deviations, give you a “hypothetical” upper and lower price threshold.
Let’s back up and unpack it a bit.
A standard deviation is a statistical calculation that tells you how far something has moved from the mean (or average). It’s usually stated in terms of levels: first, second, third standard deviation, etc. When volatility ramps up and price action explodes, you’ll see both standard deviation bands expand to accommodate the volatility.
So, how might you interpret Bollinger Bands? Here are a few ideas:
Overall, Bollinger Bands can help you gauge when a stock may be overextended (overbought and oversold), the direction it may be trending, and when it may be poised for a large move. Based on these three things, it might also help you determine favorable entry and exit points.
If you want to get more in-depth information on Bollinger Bands, here’s a primer.
Maybe you’ve got a trade on and you want to avoid placing a stop order that’s too tight. Perhaps you’re just looking to make a swing trade that’s well worth the effort. Or maybe you want to enter or exit a position when your stock’s price movements either settle down or show a little bit more dynamism.
What you’re trying to get a feel for is relative movement and rest. But relative to what? That’s what the average true range (ATR) indicator can help you figure out.
FIGURE 2: AVERAGE TRUE RANGE INCREASES AND THEN DECREASES. The volatility in the above candlestick chart as measured by ATR (lower panel) may have risen as the stock began trending upward, but its range of motion started to diminish as prices consolidated around the upper range. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
The ATR averages out the “daily” range—measuring an asset’s high-to-low range—over a given “lookback” period. In the example in figure 2, it’s measuring the average range of motion across a 14-day period.
Note that during the first period of consolidation (left side) the ATR fell to 20, but after the second rally and consolidation rally, the range of motion increased to an average range of 60 points (between high and low) per day. That’s a 300% jump.
How might you use this information? First off, it tells you what to expect in terms of an asset’s current range of motion. It might help you set and optimize entries and exits, as well as position size. For example, when ATR is higher than normal, you might be better served by dialing back your position unit size and letting the prices run a bit more. You don’t want to pull the trigger too soon, but widening your parameters might expose you beyond your standard risk parameters.
This is particularly true if you’re a swing trader. It might help you decide when it’s a good time to jump in or stay out depending on your strategy and risk tolerance.
Volatility is just one important factor that can help you contextualize price action in any given market. Understanding a stock’s volatility can help you anticipate price behaviors that might otherwise surprise you. If you’re analyzing volatility to make a trading decision, be sure to check other technical factors like trend and momentum as well. And of course always check the fundamentals, especially if you’re looking to buy an asset for a longer-term hold.
Karl Montevirgen 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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