What Is a Volatility Ratio
A volatility ratio is a technical measure used to identify price patterns and breakouts. In technical analysis, it uses true range to gain an understanding of how a security’s price is moving on the current day in comparison to its past volatility.
There are several different versions of volatility ratios, the most common being adaptations of average true range (ATR).
- A volatility ratio measures relative changes in an asset's price movements in order to identify trading opportunities.
- Technical traders employ true range, or the difference between the high and low prices on any given day, to reveals how volatile a stock is.
- The most common version of a volatility ratio takes the proportion of an asset's day true range to its average true range.
Understanding Volatility Ratios
The volatility ratio is a measure that helps investors follow the volatility of a stock’s price. It is one of a few technical indicators focused on volatility. In general, standard deviation is typically one of the most common measures used for following volatility. Standard deviation forms the basis for several technical channels including Bollinger Bands. Comprehensively envelope channels of many different varieties are used by technical analysts to identify price ranges and volatility patterns that help lead to trading signals. Historical volatility is also another common trendline that can be used to follow volatility.
The volatility ratio was developed to contribute to the analysis of price volatility. Across the industry volatility and volatility ratio calculations may vary. For technical analysis, Jack Schwager is known for introducing the concept of a volatility ratio in his book “Technical Analysis.”
Calculating the Volatility Ratio
Schwager’s methodology for calculating the volatility ratio builds on the concept of true range which was developed and introduced by Welles Wilder but has several iterations. Schwager calculates the volatility ratio from the following:
VR=ATRTTRwhere:VR=Volatility RatioTTR=Today’s True RangeToday’s True Range=Max−MinMax=Today’s High, Yesterday’s CloseMin=Today’s Low, Yesterday’s CloseATR=Average True Range of the Past N-Day Period
Other iterations of the volatility ratio may include the following:
VR=ATR∣TTR∣where:| TTR |=Absolute Value of MaxAbsolute Value of Max=TH−TL,TH−YC,YC−TLTH=Today’s HighTL=Today’s LowYC=Yesterday’s Close
VR=EMA∣TTR∣where:EMA=Exponential Moving Average of the True Rangeof the Past N-Day Period
Volatility Ratio Signals
Investors and traders will have their own mechanisms for following and detecting patterns from the volatility ratio. This ratio is typically plotted as a single line on a technical chart either as an overlay or in its own display window.
A higher volatility ratio will signal substantial price volatility in the current trading day. In general volatility can be a signal of disturbances or developments affecting the security’s price. Therefore, high volatility may lead to a new trend for the security’s price in either a positive or negative direction. Traders follow volatility and the volatility ratio in conjunction with other trading patterns to help confirm a trading signal for investment.