Shares digital

W hen almost any price chart is examined it is apparent that price movements take on different characteristics at different times. In a clear trend, the day-to-day movement can be relatively calm, either measured by the daily high-to-low range or by the variation in net change from day to day. At other times, when direction is less obvious, the price can move quite violently in a seemingly haphazard manner. That is the volatility of price action.

By measuring volatility we can gain a clue as to how risky a share might be to trade and, by comparing current levels with those seen historically, we might also surmise the extent to which a turning point might be occurring. By using the volatility study that looks at the daily range tops have sometimes been found to coincide with relatively high levels of volatility and bottoms are more likely to occur against a backdrop of historically low volatility. The time over which the measure is averaged is key and a variation on this approach suggests it is better to look at two measures of volatility, one with a long average and one with a short, as tops tend to be accompanied by high volatility over the longer term while lows can see spikes in short-term volatility as capitulation leads to short-term panic selling and a selling climax that is likely to appear on the chart as a spike bottom, or ‘V’ bottom. See the example chart.

A volatility study should be considered as a confirmatory indicator perhaps to be used with other measure such as moving average bands to help in determining the timing of trading opportunities. Additionally, volatility can be used to vary the time period of other market measures such as moving average lengths, so as to improve those studies’ responsiveness during turbulent trading periods.

In the US, the Chicago Board of Trade publishes a volatility index for the S&P 500 index which is based on the implied volatilities of both put and call options on the index. It is used to gauge the market’s perception of risk and is colloquially referred to as the investor fear gauge. It is generally accepted that readings above 30 signal investor expectation of higher market volatility in general, while readings below 20 suggest low volatility going forward. It has also been found that very low values sometimes presage a sharp reversal in trend, for they allude to possible market complacency in respect of the prevailing trend. Similar measures are also calculated for the NASDAQ and Dow.