What are volatility indicators, and how do they work in Forex?

Each market condition requires different indicator. Traders are using range trading, trend trading, volume and volatility indicators. FX trading volatility indicators help traders identify periods of increased activity.

Volatility is one of the most important metrics for any trader, and forex traders have lots of volatility indicators to choose from. Higher volatility can mean an increased trading volume for an asset – where millions of buy and sell orders hit the market at a moment’s notice. Volatility indicators allow traders to analyze the causes of volatility. The usage of Forex market volatility indicators is based on a viewpoint that markets go from calm to volatile periods, and increased volatility can bring trading opportunities.

Core features of volatility indicators

• Volatility measures the movements of an asset’s price within a given time period
• Volatility is what brings traders profits, but is also the reason for sudden losses
• Most volatility indicators are plotted on the price chart as opposed to volume indicators, which are usually plotted below the chart
• Volatility and volume indicators are often used in conjunction, as the two are intertwined and most forex strategies function with both of them in mind
• Standard deviations from the average price is a metric that is often used to measure volatility on the market

The importance of volatility

Volatility is a key metric to consider when trading any asset class. The speed at which prices change can have a great impact on the strategies traders select to implement. For instance, a highly volatile currency pair would attract significant attention from forex day traders and scalpers, as they can place dozens of orders throughout the trading session. Volatility on the forex market can also be attributed to periods when the New York and London forex sessions coincide, which leads to more market participants trading major pairs, which increases liquidity. Liquidity is essential for forex traders, as it determines the spread charged by brokers. Lower spreads can make room for more versatile and reliable trading strategies. Volatility indicators Forex traders use vary from markets to markets. Each currency pair chart moves differently on charts. For creating the best trading strategy that fits your personality, it’s important to learn as much as you can about different indicators, patterns and fundamentals, create your own trading systems and test them before going live. In this volatility indicators guide, we’ll discuss various indicator types.

Moving averages

Moving averages are some of the most popular technical indicators available to traders. Moving averages provide a constantly updating price and smooth data to indicate the direction of an asset’s price movements. Moving averages are generally used for trading trends. Moving averages definition and core features

• Moving averages are among the basic indicators used in forex trading
• A moving average shows the arithmetic mean of an asset’s prices over a specified period of time
• Moving averages are plotted on the price chart
• MAs can operate on various timeframes. 20, 50, 100 and 200-day periods are some of the most popular timeframes used by forex traders
• Simple and exponential moving averages are the two types of MAs used by traders
• Breakout and crossover strategies use moving averages to send out buy and sell signals
• MACD and Bollinger Bands are the two indicators that use moving averages in their values

Moving averages calculation

Simple and exponential moving averages are calculated using different formulas.

The formula for calculating SMAs is as follows:

SMA = (A(1) + A(2) + … + A(n)) / N

Where:

A = average in period N

N = number of periods

Exponential moving averages add a smoothing factor to the calculation. The smoothing factor serves as a multiplier in the EMA formula:

[2 / (Selected time period + 1)]

The current EMA value is calculated by combining the smoothing factor with the previous EMA:

EMA(t) = [V(t) x (s / (1 + d))] + EMA(y) x [1 – s / (1 + d)]

Where:

EMA(t) = today’s EMA

V(t) = today’s value

EMA(y) = yesterday’s EMA

S = Smoothing factor

D = number of days

Moving averages example in forex

To get a better understanding of how moving averages work in forex, traders must first consider the differences between simple and exponential moving averages.

A simple moving average assigns the same weight to each and every price point across a given trading period. Exponential moving averages assign more weight to the latest price points, which makes the EMA closer to the actual price chart.

The difference between the two is even more evident when we look at charts for visual cues.

The charts show the SMA and EMA plotted on the GBP/JPY price chart. The EMA follows the price much more closely and is barely distinguishable from the chart. The SMAs, however, are further away from the price – with the closer lines representing shorter timeframes.

This difference between SMAs and EMAs is one of the reasons why most traders choose to use EMAs in their strategies.

Bollinger Bands

Bollinger Bands are another popular lagging indicators used by Forex traders. Bollinger Bands are also known as volatility indicator. The indicator plots a 20-day SMA on the price chart and two bands that are two standard deviations away from the SMA on both sides. These bands serve as support and resistance levels and when the price crosses them it generates overbought and oversold signals for traders.

Bollinger Bands definition and core features

• Bollinger Bands are lagging indicators that show increased volatility. The indicator is used for identifying short term sharp price action and generate entry and exit points.
• Bollinger Bands are plotted two standard deviations (positive and negative) apart from a simple moving average of an asset’s price
• Much like other volatility indicators, BB are plotted on the chart, not below it
• The indicator uses two bands and a 20-day simple moving average
• MACD and RSI are two indicators that are frequently used alongside Bollinger Bands
• The expansion and contraction of Bollinger Bands indicates changing volatility on the market

Bollinger Bands calculation

Bollinger Bands can be calculated using the following formula:

BOLU = MA (TP, n) + m * σ [TP, n]

BOLD = MA (TP, n) – m * σ [TP, n]

Where:

BOLU = the upper Bollinger band

BOLD = the lower Bollinger band

MA = moving average

TP = typical price = (High + Low + Close)/3

N = number of days in smoothing period (20)

M = number of standard deviations (2)

σ [TP, n] = the standard deviation over last n periods of TP.

Bollinger Bands example in forex

To get a better understanding of how Bollinger Bands work in forex trading, let’s look at the GBP/JPY chart with the Bollinger Bands plotted on it.

To identify possible reversals on the chart, traders need to look for the highs and lows of the bands and any crossovers made by the price line.

Bollinger Bands can be used to invalidate breakouts in a three-step process:

• The price creates a reaction above the upper Bollinger Band
• A pullback happens toward the middle band
• Price moves above the prior high but fails to touch the upper Bollinger Band

New lows can be confirmed in a four-step process:

• The price forms a reaction low, which may or may not be below the lower Bollinger Band
• The price bounces towards the middle band
• The price reaches a new low
• The pattern is confirmed by a strong move from the second low, which forms a breakout

Average true range (ATR)

The average true range, or ATR, is one of the highly important commonly used FX volatility indicators.

ATR definition and core features

• Average true range uses absolute values of current and previous closing prices to find a simple moving average
• ATR typically uses a 14-period timeframe on daily, weekly, monthly charts
• A pair experiencing high volatility will have a high ATR, and vice versa
• ATR is plotted below the price chart
• ATR measures volatility and not the direction of a pair’s price

ATR calculation

To calculate the average true range, let’s look at the formula below:

TR=Max[(H − L), Abs(H − CP), Abs(L − CP)]

ATR=(1 / n) (i=1)∑ (n) TR(i)i

Where:

TR(i) = A particular true range

N = The time period employed

The number of signals generated by the ATR depends on the length of timeframe used. If a trader wants to use a 10-day timeframe, they will have to calculate:

• The maximum of the absolute value of the current high – the current low
• The absolute value of the current high – the previous close
• The absolute value of the current low – the previous close

The same calculation would be done for the 10 latest trading days, which are then averaged to find the first 10 values of the ATR.

ATR example in forex

To better understand how the ATR works in forex, lets; look at the indicator plotted below the GBP/JPY price chart.

When the ATR value rises above the most recent closing price, this can signal traders to enter the market. Another method of using ATR is to place trailing stops under the highest point the pair has reached since entering the market. The distance between the highest point and the stop level can represent a multiple of the ATR value. This is also called the “chandelier exit” strategy.

While a solid tool in its own right, using the ATR comes with some limitations. No single ATR value can be a definite indicator that a trend will reverse, or a breakout will happen. Also, the ATR only measures volatility and not price direction.

Using volatility indicators trading forex can greatly enhance trader’s ability to make money when markets are making sharp moves.

Parabolic SAR

The parabolic stop and reverse, or SAR, is a technical indicator used to find the direction of a trend and identify likely reversals.

Parabolic SAR definition and core features

• The parabolic SAR is used to determine the possible reversals and trend direction on the market
• Stochastic, moving averages and the ADX are commonly used indicators alongside the parabolic SAR
• A trailing stop and a stop and reverse are used to find entry and exit points on the chart
• The parabolic SAR is placed on the price chart and follows it closely

Parabolic SAR calculation

The parabolic SAR uses extreme prices and acceleration factors to calculate its value:

Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP – Prior PSAR)

Downtrend: PSAR = Prior PSAR – Prior AF (Prior PSAR – Prior EP)

Where:

EP = Highest high for an uptrend and lowest low for a downtrend, which is updated every time a new EP is reached.

AF = Default of 0.02, which increases by 0.02 every time a new EP is reached, with the maximum value being 0.20.

Parabolic SAR example in Forex

To better understand how the parabolic SAR works in forex, let’s look at an example of the indicator plotted on the GBP/JPY price chart. Examples of volatility indicators can make usage of the indicators easier.

The blue arrows dotted all over the GBP/JPY price chart represent directional changes. Traders can use this data to place stop-losses on the parabolic SAR dots. When the price goes beyond the dot, this can signal a reversal.

Keltner channel

Similar to Bollinger Bands, Keltner channels place bands over the price chart. These bands measure volatility and are used to determine the direction of trend.

Keltner channel definition and core features

• Keltner channels use ATR to measure volatility. When the ATR breaks above or below the Keltner bands, this signals trend continuation
• The Keltner bands are placed on either side of the price chart
• The typical EMA used in Keltner channels is for a 20-day period
• The bands are typically placed at a value two times the ATR, above and below the EMA. However, the multiplier is customizable
• The price reaching the upper Keltner channel is a bullish signal, and vice versa
• When the price alternates between the upper and lower Keltner channels, this represents the support and resistance levels for the price

Keltner channel calculation

Let’s look at the calculation steps required to find Keltner channels:

Keltner Channel Middle Line = EMA

Keltner Channel Upper Band = EMA+2∗ATR

Keltner Channel Lower Band = EMA−2∗ATR

where:

EMA = Exponential moving average (typically over 20 periods)

ATR = Average True Range (typically over 10 or 20 periods)

The below steps describe the process of calculating Keltner channels:

• Find the desired period EMA (typically 20 periods)
• Calculate the desired period ATR (typically 20 periods)
• Multiply the ATR by your multiplier of choice (typically 2) and subtract the number from the EMA (this is the lower band value)
• Multiply the ATR by your multiplier of choice (typically 2) and add the number to the EMA (this is the upper band value)
• Repeat these steps for each period of the EMA

Keltner channel example in forex

Let’s look at a practical example of the Keltner channel placed on the GBP/JPY price chart.

Traders can use this data to identify points where the price goes above or below the Keltner channel. When the price dips below the channel, this can be a signal to go long. When the price goes above the Keltner channel, it is likely to dip and traders can go short.

One issue traders may have with Keltner channels is if the bands are either too tight or too wide, which can generate too many signals if the bands are too tight, or very few if the bands are too wide. Choosing a sensible EMA period is important. This is why most traders opt to use the 20-day EMA when using Keltner channels.

Donchian channel

Donchian channels are one of the volatility indicators Forex traders actively use. It’s somewhat similar to Keltner channels. The indicator places the price between upper and lower bands – with a median band in the middle. Donchian channels are used to identify major breakouts and reversals in the market.

Donchian channel definition and core features

• The upper and lower Donchian bands represent the highest and lowest prices of an asset over a set period of time
• The middle Donchian band is the average between the upper and lower bands
• Donchian bands are placed on the price chart
• MACD, stochastic and volume indicators are often used alongside Donchian bands
• Donchian channels can be prone to generating false signals from time to time

Donchian channel calculation

UC = Highest High in Last N Periods

Middle Channel=((UC+LC)/2)

LC = Lowest Low in Last N periods

where:

UC = Upper channel

N = Number of periods

Period = Minutes, hours, days, weeks, months

LC = Lower channel

Upper Channel:

• Choose the desired time period
• Compare the high points for each period
• Select the highest point
• Plot the results

Lower Channel:

• Choose the desired time period
• Compare the low points for each period
• Select the lowest point
• Plot the results

Middle Channel:

• Choose the desired time period
• Compare the high and low points for each time period
• Find the average between the highest and lowest points
• Plot the results

Donchian channel example in forex

To better understand how Donchian channels work in practice, let’s look at the indicator plotted against the GBP/JPY price chart.

Donchian channels show the highest and lowest price points over a set period of time. The width of each channel depends on the volatility of the market. The top line of the Donchian channel shows the extent of bullish power, while the bottom shows bearish power. Traders can use this information to measure the volatility and strength of bullish and bearish trends in the market.

Relative vigor index (RVI)

The relative vigor index, or RVI, is a technical indicator that measures the direction of volatility. Unlike the relative strength index, or RSI, RVI uses the standard deviation of price changes to calculate the RVI value.

RVI definition and core features

• The relative vigor index is similar to the relative strength index, but it uses a standard deviation of price changes
• The RVI is plotted below the price chart
• Divergences between the price and the RVI suggest a trend change in the near term
• Like other momentum indicators, RVI can be used alongside volume indicators for maximum effect
• The RVI operates on the observation that prices close higher than they open on uptrends, and vice versa

RVI calculation

Numerator = (A + (2 × B) + (2 × C) + D) / 6

Denominator = (E + (2 × F) + (2 × G) + H) / 6

RVI = SMA of the numerator for N periods / SMA of the denominator for N periods

Signal line = (RVI + (2 × I) + (2 × J) + K) / 6

Where:

A = Close − Open

B = Close − Open One Bar Prior to A

C = Close − Open One Bar Prior to B

D = Close − Open One Bar Prior to C

E = High − Low of Bar A

F = High − Low of Bar B

G = High − Low of Bar C

H = High − Low of Bar D

I = RVI Value One Bar Prior

J = RVI Value One Bar Prior to i

K = RVI Value One Bar Prior to j

N = number of periods

How to calculate the RVI:

• Choose a desired N period
• Find the open, high, low and close values for the current bar
• Find the open, high, low and close values for prior bars
• Calculate the simple moving averages for the numerator and denominator over the N period
• Divide the numerator value from the denominator value
• Find the signal line and plot it on a graph

RVI example in forex

Let’s look at a practical example of the RVI, with the indicator plotted below the GBP/JPY chart.

RVI can measure potential trend changes. Divergences and crossovers are two important patterns to consider when using the RVI:

• Divergence – A divergence between the price and RVI suggests a near-term change in the RVI’s trend. When the price of a currency is rising, but the RVI is falling, the price is likely to reverse
• Crossover – When price crosses over the signal line, a bullish trend is likely to form. When the price crosses below the signal line, a bearish trend is likely coming

FAQs on volatility indicators in forex

What are the types of volatility indicators?

Forex traders have access to various volatility indicators, such as the relative volatility index, Bollinger Bands, moving averages, Donchian and Keltner channels, etc. These indicators measure the relationship between the volatility and price movements of an asset to send out buy and sell signals and identify support and resistance levels.

Do volatility indicators work in Forex?

Yes, however, keep in mind that trading indicators work best when they’re used as intended. Volatility indicators work in certain markets. High volatility creates uncertainty for most traders, and indicators can help traders navigate the market with relative ease.

What do volatility indicators show?

Volatility indicators show the effect of price volatility on price direction. Volatility often increases when a breakout or reversal is about to happen in the market, and traders can prepare trades according to the signals sent out by the volatility indicators. The indicators show the rise and fall of trading activity in terms of making sharp price movements.