Giving ourselves a trading framework of likely price movements to work within can be very advantageous. By using simple indicators, we can approximate how much the market is likely to move today or tomorrow. While we cannot come up with an exact figure, even a small edge can result in a significant difference in profit for traders. For day traders this can be especially helpful. Having insight into how much movement is probable the following day can provide for finely tuned entries/exits, profit targets and stop levels. Here we take a look at powerful indicator that can help traders predict market volatility.
TUTORIAL: Economic Indicators
Predicting the Market: A Trader's Best Weapon
A common problem for day traders is not knowing how far a trend is likely to go or within what scope of movement price is going to be limited. When making trades, it is important to be aware of where probable movement extremes are, based on the current trading climate. This goes beyond using basic support and resistance levels, which may not be in the probable proximity of intra-day movements. In this way, stop levels can be placed outside of market noise, and profit targets can be placed in price areas that are highly likely to be hit. (Find out how you can combine the best of both strategies to better understand the markets. Check out Blending Technical And Fundamental Analysis.)
The ATR is our base indicator; it provides us with the average movement over a chosen period. The SMA and Bollinger Bands® will be applied to ATR. Combining indicators in this way can provide additional insights that are not seen by using the single indicator.
ATR will use a setting of 1. This means ATR is only concerned with the most recent period, which makes the indicator very responsive to changes in volatility but also very choppy. This is fine for use in determining whether the following day will see increased or decreased volatility. The SMA, using 20 periods, is then applied to the ATR indicator. (These technical indicators help investors to visualize trends by smoothing out price movements. See Simple Vs. Exponential Moving Averages.)
Bollinger Bands® using a period of 20 and 2 standard deviations are also applied to the ATR.
The SMA provides a visual trend of which way volatility is moving: If the trend is moving lower, then daily ranges are narrowing. If the trend is rising, then daily ranges are expanding.
The Bollinger Bands® provide highly useful information. Using two standard deviations, the Bollinger will capture approximately 95% of the price action. However, this percentage assumes a normal distribution, and prices cannot be assumed to be normally distributed. Therefore, the amount of price action that is captured by the Bollinger Bands® will vary but will still contain the vast majority of trading action.
We can see in Figure 1 that the ATR does stay within the Bollinger Bands® much of the time, and when the bands are penetrated, volatility retreats back to within the bands (usually within the following day). This is why Bollinger Bands® are used: They react to changes in volatility.
The information can be used in several ways. By looking at Figure 1, we can see how the indicator looked from January through to the end of April 2010.
|Figure 1: S&P 500, Daily with Compound Indicator|
This method can be applied to any individual stock, index or ETF to help gauge likely movements. The ATR chart shows that when extremes are hit (penetration of the Bollinger Band®), volatility reverses course, in most cases the very next day.
If on the previous day the ATR had broken out or moved to the upper Bollinger Band®, it is likely that the following day will see reduced volatility. But, this is not always the case. On January 20, the upper band was hit, indicating that volatility would likely retreat. The following day saw higher volatility; it wasn't until January 22 that volatility started to pull back.
This information can be used to discern what the likely low and high areas of the day will be. For this four-month period, the lowest reading for the ATR was just under five points (horizontal white line). Therefore, the trader can assume there will be at least a five-point movement from the previous close. Looking at the arrow corresponding to April 16, we see the upper Bollinger Band® was penetrated with an ATR reading of 24.90. It is highly likely that volatility will retreat from this level. Therefore, the trader can assume that price will not move more than 24.90 points from the April 16 close on the next trading day. In this case, the following trading day was April 19 and the ATR reading on that day was 14.19, which respresents a significant retraction in volatility. (Find more profitable entry and exit locations with this standard indicator. To learn more, read Measure Volatility With Average True Range.)
When using this method on any trading instrument, a movement to the upper extreme means a likely decrease in volatility the following day. Movement to the lower band means a likely increase in volatility the next day. As was shown, the method does not always work but can provide a way for traders to better estimate what the price span is going to be the following day. A minimum movement and a probable maximum movement can often be established. Also, by using the moving average as a guide to see if overall volatility is increasing or decreasing, the trader can estimate the range of price movement the instrument is likely to trade within the following day.
If the ATR is well within the Bollinger Bands® and is not hitting extreme levels, then the lows and highs of the ATR for that period can be used to estimate the probable range. The SMA value can also be used to better estimate the likely daily range – these methods could have been used during the period of late February through March. However, during this time there were two signals from the lower Bollinger Band® (ATR touched the lower band) suggesting that volatility was likely to expand the following day, and it did. (Learn more on how to use Bollinger Bands® to read the markets. Read Using Bollinger "Bands" To Gauge Trends.)
How to Use the Information from Indicators
How the information that can be used is a large topic, with many potential applications. When markets are taken to extremes, they react in a corrective fashion. It should be pointed out that just because an extreme has been hit does mean the market cannot go further. Extreme movements can create larger movements as traders rush to enter or exit positions. Therefore, risk controls are still required as extreme circumstances can last longer than a trader can remain solvent.
Price direction is not the focus on this indicator. The purpose is to establish a baseline for a likely price span; therefore, a probable change in volatility does not indicate if movement will be higher or lower.
The Bottom Line
By combining ATR, SMA and Bollinger Bands®, we create a powerful indicator that tells us whether volatility is likely to contract or expand the following day. When the ATR level hits the lower Bollinger Band®, it means volatility is likely to expand the following day. When the upper Bollinger Band® is hit, volatility is likely to retreat. When we consider the trend of the SMA, and absolute lows or highs of the ATR readings over a given period, a trader can estimate a range of values within which the market will likely move within the following day. These values can then be used to place reasonable stops or probable profit targets, a process that can be applied to most tradable instruments. The indicator does not provide feedback on direction, only on likely contraction or expansion of price movement. (There's a simple but powerful tool to help you implement your stock-investment strategy. Find out more by reading The Stop-Loss Order - Make Sure You Use It.)