Traders and analysts rely on a variety of different indicators to track volatility and to determine optimal exit or entry points for trades. While high volatility is often a deterrent for a risky trade, increased fear during extreme market moves can also create buying opportunities and provide an exceptional trading ground for experienced investors.
On the other hand, periods of low volatility—accompanied by investor complacency—can warn of frothy market conditions and potential market tops. Some of the most commonly used tools to gauge relative levels of volatility are the Cboe Volatility Index (VIX), the average true range (ATR), and Bollinger Bands®.
- Volatility can be measured in a number of ways, including VIX, ATR, and Bollinger Bands.
- VIX is a measure derived from options prices and reflects the current implied volatility reflected in a strip of S&P 500 Index options.
- Average true range is a charting indicator that shows how wide a stock or commodity's daily trading ranges have been over time, with high readings reflecting higher volatility.
- Created by John Bollinger, Bollinger Bands® are helpful in seeing periods of quiet and explosive trading.
Cboe Volatility Index
The Cboe Volatility Index is one of the most widely watched gauges of market volatility. Updated throughout the trading day and known by its ticker symbol, VIX, the index is computed using an option-pricing model and reflects the current implied or expected volatility that is priced into a strip of short-term S&P 500 Index options.
Because large institutions account for a large portion of trading in S&P Index options, their volatility perceptions (as measured by VIX) are used by other traders to help get a reading of likely market volatility in the days ahead.
The Cboe Volatility Index stays between 12 and 35 the majority of the time, but it has also dropped into the single digits and has rallied to more than 75. Generally, VIX values higher than 30 indicate increased volatility, while values in the low teens are indicative of low volatility.
Derivatives, such as futures and options, on VIX are actively traded. In addition, leveraged exchange-traded funds based on the volatility index—like the ProShares Ultra VIX Short-Term Futures ETF (UVXY) and its partner ProShares Short VIX Short-Term Futures ETF (SVXY)—exist as well.
Average True Range
While VIX measures S&P 500 volatility, the average true range indicator, developed by J. Welles Wilder Jr., is a technical chart indicator that can be applied to any stock, exchange-traded fund, forex pair, commodity, or futures contract. ATR calculates what Wilder called "true range" and then creates the ATR as a 14-day exponential moving average (EMA) of the true range. The true range is found by using the highest value generated by one of three equations:
True range = Current day's high minus the current day's low
True range = Current day's high minus the previous day's close
True range = Previous day's close minus the current day's low
The ATR is then created as an EMA (computed using the highest value found when the three equations are solved). A larger ATR indicates higher trading ranges and thus increased volatility. Low readings from the ATR are generally consistent with periods of quiet or uneventful trading.
Bollinger Bands® is another charter indicator and consists of two lines or bands, which are two standard deviations above and below the 20-day moving average, which appears as a line in between the two bands. Widening of the bands shows increased volatility, and narrowing of the bands shows decreased volatility. Like ATR, Bollinger Bands® can be applied to any stock or commodities chart.
The Bottom Line
Market volatility goes through cycles of highs and lows. Analysts watch the direction of market movement when there is a sharp increase in volatility as a possible indication of a future market trend. While VIX is useful in seeing overall levels of volatility of the S&P 500 Index, ATR and Bollinger Bands® can be applied to stocks, commodities, forex, indexes, or futures using any number of charting applications.