The volatility ratio indicator is designed as a measure of price range. It is used by traders and analysts to mark existing price ranges and to watch for trading signals generated by breakouts from the price range. The indicator is calculated based on a current true price range and a previously existing true price range. On a chart, the volatility ratio is typically plotted as a line and appears in a second window below the main chart window.
The volatility ratio is calculated as follows:
Current True Range = Maximum (average of current day's high and yesterday's close) - Minimum (average of today's low and yesterday's close)
Previous True Range over X number of days = HIGH (average of the high prices of each day over time period X) - LOW (average of the low prices of each day over time period X)
Volatility Ratio = Current True Range / Previous True Range over X number of days
The default, most commonly used values for X when calculating the previous true range are 10 or 14.
The volatility ratio identifies for traders time periods when price has exceeded its most recent price range to an extent significant enough to constitute a breakout. Precise readings that indicate a breakout are usually adapted by traders to the specific stock or market they are trading, but a commonly used reading is 0.5. This level represents the point at which the current true range is equal to twice the previous true range. To confirm breakout signals given by the volatility ratio indicator, traders often use other technical indicators such as volume, since trading volume generally increases sharply during market breakouts.