When studying a stock or a market to trade, we often need to study the current volatility cycle to determine which strategy to use – or avoid.
Measuring volatility(NYSEARCA:VXX) is especially important if you wish to use any sort of option strategy with a stock or ETF.
Let’s take a look at three quick tools you can use to measure where a stock is trading in its volatility cycle.
We’ll use the SP500 (NYSEARCA:SPY) as our proxy and overlay three simple technical analysis tools:
- “High minus Low” which simply subtracts the low of the day from the high of the day (pure price)
- Average True Range – similar to the “high – low” indicator, but takes into account overnight gaps
- Bollinger Band Width - subtracts the lower BB value from the upper BB Value (standard deviation)
The High-Low formula is a custom indicator that simply returns the price range of a particular trading day.
The Average True Range (ATR) indicator uses the same logic but also takes into account overnight gaps in its formula while calculating the average value over 14 days (default) or any time period you specify.
Finally, the Bollinger Band Width measures the difference of the value two standard deviations above the 20 day mean (average) and the value two standard deviations below the 20 day average.
With the ATR and BB-Width Indicators, you can increase or decrease the calculation period for greater sensitivity.
For example, an ATR look-back period of 20 will be “smoother” than a period of 10 which would be more “spiky.”
The same would be true for BB-Width where you could increase or decrease the average (mean) along with the Standard Deviation (1.5, 3, 4, etc).
The goal is to determine the current and potential future volatility by studying the Volatility Cycle from historical prices.
Volatility tends to go through cycles of high phases and low phases. Specifically, a period of low volatility now tends to erupt in a period of high volatility in the future.
A period of high volatility (often associated with a sharp price decline) tends to settle-down into a lower volatility phase in the future.
From a psychological standpoint, periods of complacency/stability tend to move to phases of excitement/instability.
Here’s a recent example of Volatility Cycles in Apple (AAPL):