There are several volatility indicators available for stock traders and analysts to use when determining entry and exit points for trades. Volatility is often used as a deterrent for a risky trade, but increased fear or complacency in the market can make for an exceptional trading ground for experienced investors. Some of the most commonly used tools that determine volatility are the volatility index (VIX), the average true range (ATR) indicator and Bollinger Bands.
The volatility index tracks an extensive range of put and call options on the S&P 500 Index and aims to act as a predictor of market volatility for at least the next 30 days forward. Because large institutions account for the bulk of trading in S&P Index options, their trading in the options market is used by other traders to help them get a reading of likely market volatility in the days ahead.
The VIX shows a reading between 18 and 35 the vast majority of the time, but it has gone as low as 10 and as high as 85. VIX values higher than 30 indicate increased volatility, while values below 20 are indicative of low volatility.
Derivatives that track the VIX are heavily traded. The leveraged version of these products are some of the most volatile trades out there, items like the Proshares TR 2x leveraged Ultra VIX Short (NYSE: UVXY) and its partner SVXY. Some in the trading world call these heavily volatile trading vehicles 'widowmakers,' and it is not advisable to trade these without significant experience.
Average True Range
The ATR indicator, developed by J. Welles Wilder Jr., 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 following 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 of the highest value found when the three equations are solved. A larger ATR indicates higher volatility. Traders use this tool to determine when they should enter a trade, considering exponential moving averages, when used in conjunction with the volume of trades.
Bollinger Bands measure two standard deviations above and below the 20-day average and plot lines representing these levels on a chart, along with a line between the two bands that shows the 20-day moving average. Widening of the bands shows increased market volatility, and narrowing of the bands shows decreased volatility. Typically when a candle or other trading marker touches the top band, it is a potential candidate for a retracement.
The Bottom Line
Volatility in the stock market goes through cycles of high and low. Analysts watch the direction of market movement when there is a sharp increase in volatility as a possible indication of a future market trend. Using these indicators, they can determine when a trade might be profitable, or simply too risky to enter.