Explore how to use volatility tools to refine your approach to trading

Volatility is an essential component in financial markets. It measures the speed and distance of an instrument or asset class’s movement.

• Economic calendar events (Like Non-Farm Payrolls)
• The event or absence of unpredictable headlines
• Speeches from political figures
• Central bank meetings (like the FOMC)
• Earnings

In general, any unpredictable component (also known as ‘not priced in’) coming from new data or headlines will add to the volatility of trading products.

For example, in a hypothetical scenario, let’s assume the usual or average volatility for EUR/USD is 400 pips per session. In such a case:
- A day when the pair moves 800 pips would be considered a higher volatility session

- A session where the pair moves 1500 pips or more would be considered an extreme volatility session.

- A session where the pair moves 200 pips would be considered a low volatility session.

Most banking institutions will shift the composition of their portfolios depending on the expected change in volatility.

For example, higher volatility expectations will traditionally make portfolio managers shift their positioning from high-risk assets to more “safe” products, like US Treasury Bonds. The same could be found in equities, with appetite going from the tech sector towards consumer defensive stocks as volatility is expected to increase.

Despite it not being a given, volatility tends to be more negative for risk assets, however, in some rare cases, volatility may rise with a stock rise (if most asset managers are positioned for a down-move in stocks, for example).

Some products and indicators, widely discussed in financial markets, are commonly used by traders and experts to try to predict future movement, hedge market views, and generally to consult the current state of markets.

The VIX (or Volatility Index) is the most commonly known volatility product.

Often called the “fear gauge”, it measures the market’s expectations of volatility in the S&P 500 over the next 30 days, based on options pricing.

Generally, a VIX spike could be related to some bad geopolitical headlines scaring markets, leading to more erratic stock and hence stock options moves.

The MOVE Index is another popular volatility product monitored by bond traders and more sophisticated participants.

Often referred to as the “VIX of bonds”, it tracks expected volatility in US Treasury yields (spanning 2- to 30-year maturities) using options pricing in the Treasury market, much like the equity VIX.

In commodities, traders often follow the OVX for WTI crude oil volatility and the GVZ for gold.

FX participants also monitor the JP Morgan G7 Volatility Index for currencies, which reflects implied volatility across the major G7 pairs.

On-chart volatility indicators provide volatility measures and extremes directly from candlestick opens and closes.

One of the most commonly used on-chart volatility indicators is the Bollinger Bands indicator, developed by John Bollinger during the 1980s.

This indicator's basis is a 20 Simple Moving Average (or SMA), and from there, standard deviations are added to the SMA to create “volatility boundaries.” This triggers buy signals when the lower boundary is attained and short signals when the upper boundary is attained. Traders often use these boundaries to identify potential areas of interest, though prices can remain outside these bands for extended periods during strong trends. These are theoretical signals that often fail, so they should be considered as one of many input signals to your trading strategy.

The idea is that volatility tends to mean-revert, leading signals to “fade” the move at volatility extremes.

When volatility increases, Bollinger Bands widen and vice versa.
Historically, volatility moving too fast may lead to prices exceeding their boundaries.

Very similarly to Bollinger Bands, some traders prefer to use Donchian Channels¹ or Keltner Channels².

Usually combined with other indicators like the MACD or RSI, they both use different mathematical formulas, but also provide upper and lower volatility boundaries to give oversold and overbought mean-reversion signals.

Those Channels provide different signals, and it is subject to the individual trader to choose which one they want to use on their charts.

Off-chart volatility indicators will display a new pane above or below traders’ charts, identical to the RSI, and provide measures of higher/lower volatility.

The most commonly used is the Average True Range (or ATR).

The ATR measures market volatility by averaging the size of price moves (high–low ranges, including gaps) over a chosen period, usually 14 days, and oscillates higher (implying higher volatility) or lower (the inverse).

Similarly to the ATR, the Chaikin Volatility index can also be used, which uses different measures of calculation, and can provide another option for the ATR, depending on your preferences.

Derived from the Average True Range, the Choppiness Index also gauges whether the market is trending (low “chop”) or ranging (high “chop”).

Volatility is essential for traders and financial market participants.

Providing direction on how much a given product is expected to move, helping to know what asset classes could see more inflows, and feeding trading signals, there many uses and ways to measure it.

Using a strategy involving volatility may help you refine your entries and assess if a market has more chances to be rangebound or trending.