How to improve trading performance using volatility indicators

Two common indicators used by traders to help identify volatility are Bollinger Bands and average true range.
By taking a position on the VIX, also called the 'fear gauge', you may balance out other stock positions in your portfolio and hedge your market exposure. Image: Adobe Stock

Two useful indicators used by traders to improve performance are Bollinger Bands and average true range (ATR).

Both are volatility indicators used to identify the likely upper and lower levels of a trading range. Knowing this, the trader can profit by buying a security at the lower end of the range and selling when it reaches the upper end – and vice versa.

Bollinger Bands

Bollinger Bands are great in helping identify which phase of volatility we are in and how we could approach trading in this market.

The chart below shows the area in the Bollinger Bands shaded in yellow.

Source: IG Markets SA

Where the bands narrow, this indicates lower volatility. For those already in a trade, the narrowing bands would suggest having smaller profit expectations.

Low volatility is often read as a sign of a sideways-moving market. Studies have been done which show that a high percentage of traders prefer to focus on sideways rather than trending markets.

Wide Bollinger Bands are indicative of a trending market, in which case traders can set larger profit targets – wide bands indicate higher volatility with more extended price moves.

“In sideways markets, you can look to trade between the levels of the range defined by the Bollinger Bands or merely just wait for a breakout of this range,” says Shaun Murison, senior market analyst at IG Markets South Africa.

“If the Bollinger Bands are moving further apart, this could suggest the price of a security is breaking out of a narrow range and moving into a new trend. Traders will look to identify this new trend and position accordingly.”

Average true range

ATR is popular with traders as it shows how much a market is likely to move over the course of a week, day, hour, or any time frame you choose. This is particularly useful in helping assess how much money is on offer (take profit) or at risk (stop loss) over whichever trading time frame you choose.

The chart below shows gold in US dollars, and the ATR is represented in the blue line below this.

In June 2022, the ATR chart spiked upwards at a time when the average gold price range was $26. Since then, the ATR has dropped to reflect the fact that gold is currently trading in a $20 range. This helps traders to establish where to put their take profit and stop loss levels.

ATR applied to gold

Source: IG Markets SA

Volatility is cyclical

Volatility is cyclical in nature and an interesting way of trading this cycle is through the VIX (Volatility Index).

The VIX is often referred to as the ‘fear gauge’ as it reflects sentiment on the S&P 500 Index. When the VIX is rising, it suggests increased risk and fear. When it is falling it highlights a lower perceived risk in the marketplace.

Traders can take positions in the VIX Index relative to their expectations of future volatility. For example, go long the index when we expect increased risk in the market place, or go short when we expect a decrease in risk.

The VIX is a real-time volatility index, created by the Chicago Board Options Exchange (CBOE). It was the first benchmark to quantify market expectations of volatility. But the index is forward looking, which means that it only shows the implied volatility of the S&P 500 (SPX) for the next 30 days.

While the VIX only measures S&P 500 volatility, it is commonly used as a benchmark for the entire US stock market. This is why the VIX is also known as the fear index, as it measures the level of market fear and stress.

The chart below shows the S&P 500 Index versus the VIX Index. The VIX Index moves more or less in a mirror image to the S&P 500, which explains why it is a preferred instrument for hedging against expected stock market declines.

S&P 500 versus the VIX Index

Source: Trading View

Why trade the VIX?

VIX-linked instruments have a strong negative correlation with the stock market, which has made them a popular choice among traders and investors for diversification and hedging, as well as pure speculation.

By taking a position on the VIX, you could potentially balance out other stock positions in your portfolio and hedge your market exposure.

Let’s say that you have a long position on the stock of a US company that was a constituent of the S&P 500. Although you believe it has long-term prospects, you want to reduce your exposure to some short-term volatility. You decide to open a position to buy the VIX with the expectation that volatility is going to increase. By doing so, you might balance out these positions.

If you were wrong, and volatility didn’t increase, your losses to your VIX position could be mitigated by gains to your existing trade.

About IG Markets

IG Markets South Africa was established in 2010 and is regulated by the Financial Sector Conduct Authority (in South Africa) as an over-the-counter derivative provider and an authorised financial services provider (FSP No 41393). It has an office in Sandton to service its thousands of South African clients. Its board and senior management in South Africa consist of largely South Africans making it a truly South African operation. As one of the biggest employers in the online broking category, it is proud to be playing a leading role in the growing financial services industry in South Africa.

Note that CFD losses can exceed your deposits.

IG Markets is part of the LSE-listed IG Group, which has a market cap of £3.4 billion (R71.4 billion). It has more than 330 000 active clients worldwide.

You can access IG Markets at https://www.ig.com/za

Brought to you by IG Markets South Africa.

Moneyweb does not endorse any product or service being advertised in sponsored articles on our platform.

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