Beyond technical analysis and chart patterns, there is an important section of technical analysis that can provide traders with an edge. It is the section on volatility indicators, and there are a lot of them. Before explaining the technical aspects of volatility, I will first clarify what it is. If the price has traded in a small range and is stable for some time, the volatility is said to be low. Volatility measures the fluctuations in price action, and the rate of change of those fluctuations. Traders will see the first signs of volatility whenever the market starts to become more anxious. Indication of anxiety can be observed from wider price fluctuations. This is the opposite of the market that is calm with very minimal price action. Not considering volatility conditions can result in a trader applying trading strategies that are not appropriate, especially for binary options traders.
Volatility can be very rewarding for binary traders who are using deep out-of-the-money or out-of-the-money strategies. These strategies have a high chance of generating substantial returns, because, with higher volatility, the market can easily move from out of the money to in the money. When the market is in a transitional phase, there tends to be more volatility. Therefore, traders will perceive the high volatility environment as an indicator of potential consolidation. In contrast, a market that has low volatility can signal a breakout. There are countless indicators used by market participants to provide the volatility conditions. This article will provide a review of some of these volatility tools. Bollinger bands are one of the most popular volatility tools used by market participants. Bollinger bands consist of a moving average and two bands which are situated on either side of a moving average.
The two bands represent boundaries, and they are a standard deviation of the moving average. The standard deviation concept is used to summarize data. The most used setting of the bands is 2,20. This means the moving average used is a 20-day moving average, and the two bands are two standard deviations. This means the price action trades within the two bands 96% of the time. Bollinger bands will help us to know whether prices are at a resistance or support level, which is represented by the bands. It is important for a trader to know the relationship between the bands and the strike price, to assess the degree of likely support or resistance that will be encountered as the price action continues. For the interpretation of Bollinger bands, a trader can assess whether the bands are closer together or far apart. The closer the bands are, the higher the chance of a breakout.
A trader can also observe the direction of the bands, which can signal the potential direction of future price action. When the bands are closer to each other, it's smarter to halt trading, as the market can aggressively move against you. This condition is an attractive precondition for breakout traders. In addition to Bollinger bands, another volatility indicator that traders should seek to master and monitor is the CBOE volatility index, also known as the VIX. The VIX tracks market expectations of the volatility that will take place in the near term, and is conveyed by the s&p 500 stock index option prices. The VIX was created in the early 1990s and is considered by many market participants to be one of the best barometers of market volatility and investor sentiment. The VIX is negatively correlated with the s&p 500 and the correlation is about 90%.
The pricing of the s&p 500 is highly influenced by investor sentiment. Therefore, it's a very good idea to monitor the VIX, especially if the trader has exposure to the s&p 500. When the volatility index is on a sharp rally, the s&p 500 is more likely to have a sharp decline. Although, the VIX is not the only index that tracks volatility. There is a fix for the oil market, which is also negatively correlated with the price of Brent crude. Another mostly used class of volatility tools is the put/ call ratio. This indicator is rooted in the concept that when traders are bearish, they buy puts and when they are bullish, they purchase calls. Therefore, due to this phenomenon, traders will be able to detect the extremes in sentiment. When the sentiment is bearish, the volume of put contracts will be more than the volume of call contracts. The trick in utilising this indicator is identifying when the ratios are at extremes.
Another form of the put/call ratio can be derived from dividing the implied volatility of puts by the implied volatility of calls. Traders can track the put/ call ratio for a particular underlying market at various sources. I recommend traders use the futures markets. One does not have to be a futures trader to be able to review the futures options contracts, and they can be reviewed at NYMEX, CBOT, CME, or any other futures exchange. The fear of a recession can also result in high volatility, and those who prepare for such an event will be greatly rewarded. The United States fully recovered from the 2008 financial crisis in 2015. The hiking of rates on the 16th of December indicated a shift in the confidence in the economy of the US. In their statement, the federal reserve signalled the indicators they would be looking at when they make their future decisions on setting interest rates.
They outlined that the focus would be on inflation. The idea of rate increases invoked recessionary fears for market participants. When the economy of the United States slows down, that would increase recessionary fears and will increase volatility in the US dollar and other related markets. Traders can monitor recessionary fears by monitoring the movements in the yield curve. When the yield curve is inverted, it signals recessionary fears. It means investors find long-term debt more attractive than short-term debt. The other most followed indicator of recessionary fears is the money supply. When the money supply is at lower levels, the economy won't be stimulated due to low liquidity. After the credit crisis, banks cut their lending and this froze the economy. The recession that came after the 2008 financial crisis was very sticky due to the low levels of the money supply.
A trader just needs to follow the money supply prospects to gauge the volatility that might be present. It's recommended for traders monitor the M4 money supply, which monitors the coins and notes bank accounts. This article provided a broader view of gauging volatility by using advanced technical analysis tools including the VIX, Bollinger bands, and put / call ratios. We also outlined how to monitor the yield curve and money supply to track emerging fear of recession.