From the May 2014 issue of Futures Magazine • Subscribe!

Volatility and volume reveal value

Volume and volatility are critical measures of market activity. Here, we’ll review both and demonstrate how they can be used to analyze markets.

Let’s start with volatility. For many, volatility is best represented by the statistical measure known as standard deviation. Standard deviation is used to measure all kinds of data. In general terms, it describes the variability or dispersion around an average, such as a security’s average price over a specified period. The larger the dispersion, the higher the standard deviation. The smaller this dispersion or variability, the lower the standard deviation.

As technical analysts, we can use standard deviation to measure expected risk and determine the significance of certain price movements. Don’t worry, you don’t have to perform the calculations for standard deviation each time you apply it. Many trading tools use standard deviation. One popular tool is Bollinger Bands, popularized by John Bollinger and present in most modern technical analysis software packages.

One caveat is that standard deviation is based on the assumption that the data are dispersed about their average in the shape of a classic bell curve. Even though empirical evidence shows that market data are not always normally distributed, most technical analysts acknowledge this shortcoming and presume certain data qualities implied by normal distributions.

In a normal distribution, 68% of the price action falls within one standard deviation, 95% of the price fluctuations fall within two standard deviations, and 99.7% of the time price will be within three standard deviations (see “All along the bell curve,” right). Using these stats, we can improve our market timing, knowing with a high degree of certainty that price should reverse direction to the average once these levels have been reached.

We can use standard deviation to time entries, take profits and exit positions when there is a change in trend. In short, when price surges or dips beyond specific standard deviation levels, the odds favor a reversal in price back to the average. This allows us to forecast an imminent trend change. However, it is crucial to trade in the direction of the longer and underlying trend. For example, when indicated to do so, you would only focus on buying the dips and locking in partial profits and tightening your protective stop during an up-trending market.

Essentially, we are watching for underlying markets to be pulled down or pushed up to extreme levels that we know are not sustainable. Then we enter a position and expect the market to move back within its normal trading range.

Volatility analysis works in all time frames, as you can see in “Short-term volatility” (below). You can see that these wild intraday movements in the market, which send most individuals into a panic, can be the perfect trading opportunity for those in the know.

The arrows are drawn by a Bollinger Band indicator that does not show the bands but does identify when price has breached an upper or lower band. The constant expansion and contraction in price and volatility determines when a signal is given. When price reaches an extreme level (one that is deemed significant enough to warrant your attention for a trade based on recent price activity), the indicator generates a trade arrow. Volatility-based tools such as this one should be used in conjunction with trend and cycle analysis to further improve market timing.

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