Volatility Ratio

DEFINITION of 'Volatility Ratio'

The 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.

BREAKING DOWN 'Volatility Ratio'

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:

Volatility Ratio = Today’s True Range / Average True Range of the Past N-Day Period

Today’s True Range = Maximum (Current Day’s High or Previous Day’s Close) – Minimum (Current Day’s Low or Previous Day’s Close)

Other iterations of the volatility ratio may include the following:

Volatility Ratio = Today’s True Range / Average True Range of the Past N-Day Period

Today’s True Range = The maximum absolute value (today's high minus low, today's high minus yesterday's close or yesterday's close minus today's low)

Volatility Ratio = Today’s True Range / Exponential Moving Average of the True Range Over the Past N-Day Period

Today’s True Range = The maximum absolute value (today's high minus low, today's high minus yesterday's close or yesterday's close minus today's low)

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.