What is volatility and how to use it to trade?

Volatility is a notion that is both fundamental and crucial to understand for all successful speculators on the stock markets. It basically enables us to determine the best moments to take position on assets according to the dynamism of their movements on the stock markets.  

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What is volatility and how to use it to trade?

Volatility: Its definition and function

 ‘Volatility’ is what we call a measure that enables us to know the strength of the movements or variations in the price of an asset over a given period. Generally speaking, the volatility is calculated on a daily basis but this analytical period can vary according to the type of market studied.

Volatility therefore enables us to obtain information on the stability, or, to the contrary, the instability of a market. We know for example that the higher the volatility, the more the observed movements will be bigger, and the contrary for the inverse situation. It is therefore more advantageous to trade during the highly volatile periods.

The professional traders and investors regularly use volatility analysis, either the historic volatility or implicit volatility.


Historical volatility and its analysis:

This volatility analysis tends to evaluate the volatility of a period prior to the actual time but it offers a certain utility for analysing the current volatility.

However, it is best to use the historical volatility as a complementary analysis and not limit yourself to a single indicator as other elements could interact with the effects of announcements to modify the level of volatility obtained such as risk aversion or general market conditions.

It is therefore only by placing all these factors side by side that we can obtain the most possible reliable level of volatility for the current period and that of the future.


Implicit volatility and its analysis:

This is the most interesting part of a volatility study as the implicit volatility indicates the coming volatility of an asset’s price. Its calculation is essentially based on the difference between supply and demand and also takes into account other influential factors as previously stated.

The so called ‘announced’ effects are often linked to strong market volatility. To correctly analyse the implicit volatility it is therefore essential to stay informed of all events and regularly consult an online economic calendar.

To complete volatility calculations it is possible to use technical indicators that have proved beneficial in the past and are commonly used by financial professionals, these include Bollinger Bands or other general indicators that use the moving averages in their calculations. These tools are often available to you for free through online brokers and banks, but they should be used in combination with your feelings and forecasts relating to the reactions of other traders.


Volatility as a risk indicator in trading:

One of the major applications of volatility when trading consists of determining the risk level of an asset and its trend. Depending on the detected volatility the investor can decide, according to the risk level, to take position or not. Here we explain how to interpret the volatility of a market using a risk evaluation:    

When the beta is higher than 1% this generally indicates a coming over reaction to a financial asset either on the rise or fall related to the market. The risk here is therefore particularly high.

On the contrary, if the beta is less than 1% we consider that the volatility of the asset concerned is displaying a lesser performance than the actual market, whether rising or falling. This weaker volatility here indicates a relatively weak risk level.

Finally, if the Beta is less than 0%, we consider that the chosen asset could react in a contradictory manner to the real movements of the market. When the market increases its points, the asset would probably therefore lose points and the contrary when the market lost some points. Here it would be advantageous to trade assets that display a beta of less than 0 when using a cover strategy.

The volatility of an asset can also be used to safeguard your investment by its lesser dependence on the moment chosen to open your positions. In fact, an asset displaying a high volatility will be more complicated to trade in this way as an entry onto the market at the end of a trend will significantly reduce your potential margins. In the case of a low volatility asset, the time you take position will have less impact on the foreseeable future profitability.


What are the different volatility indicators that you can use:

Let us now pass on to a more concrete aspect of the volatility analysis by examining a few of the principal technical indicators you can use to determine the volatility level of an asset.

The SAR, or parabolic system is one of the principal volatility indicators used in the world of trading. Its name is actually Parabolic Stop and Reverse. This volatility indicator is mainly used to define the best entry and exit points of the market.

The Momentum indicator is another interesting volatility indicator that can be found on the charts of the best trading platforms of the market. Sometimes it is also called the ROC, or Rate of Change indicator. It enables you to learn the speed at which the trend is changing. More precisely, the momentum value takes this change into account in the form of a percentage of the current market rate related to the prices over a certain number of past periods.

The different volatility bands are also interesting indicators in that they are fairly simple to interpret on the charts. These are indicators that use line charts to display the volatility rate above and below the chosen asset price. These lines, channels or bands become wider apart as the volatility strengthens and closer together when the volatility weakens. Among the most popular volatility channels, and those most commonly used on the market, we particularly note the Bollinger Bands and the Keltner channel.

The ADX indicator is another indicator that is commonly used by traders online which enables the analysis of an asset’s volatility. ADX means Average Directional Movement Index and it enables you to measure the strength of a current or past trend. Generally speaking, when this ADX indicator is less than 20 this indicates a low range period. An ADX of between 20 and 40 is the sign of a period of strong volatility and therefore high risk. And finally, an ADX that is higher than 40 is of course a sign of extremely high volatility which is obviously very high risk.

Moving averages are also an interesting indicator of volatility for online trading since their interpretation is relatively less complex than for other indicators. Using these we can also calculate the volatility using the distance between two moving averages.

Now that you know about the different technical indicators of volatility available to you, you are probably wondering which indicator is best to use for your analyses. In fact, the choice of this indicator depends greatly on your ability to understand and interpret it correctly and rapidly. We therefore recommend that you test different indicators to see which ones you are most comfortable with.

Frequently Asked Questions

How to interpret market volatility?

The volatility of a market or an asset is expressed as a percentage. As far as its interpretation is concerned, a volatility between 0 and 3% indicates a low level of volatility with a stable price and less risk. A volatility between 3 and 8% indicates a low volatility asset with a low and moderate risk. Finally, a volatility between 8 and 15% will indicate that the price fluctuation presents a real risk and that the asset or the market followed is volatile.

Which indicator should be used to analyse volatility?

The analysis of the volatility of a market can be done with different stock market indicators. The most frequently used by investors is the ATR or Average True Range, but Bollinger bands can also be used. These indicators are of course not to be calculated by yourself but are directly provided by brokers on the customisable charts of their trading platforms.

What is the volatility of a stock in the stock market?

In the stock market, the volatility of a stock or a fund is in fact an indicator that tells us about the dispersion of returns in relation to an average over a given period of time. Thus, the more volatile the market prices are, the higher the volatility of an asset may be. Volatility is often taken into account when assessing the risk of a market or an asset.

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