What Is the Volatility Ratio?
The volatility ratio is a technical measure used to identify price patterns and breakouts. It leverages true range, which helps determine how a security’s current daily price movement compares to its past volatility.
There are several versions of volatility ratios, the most common being adaptations of the Average True Range (ATR).
Key Takeaways
- The volatility ratio measures relative changes in an asset’s price movements to identify trading opportunities.
- Technical traders use true range, which is the difference between high and low prices on any given day, to gauge how volatile a stock is.
- The most common version of a volatility ratio considers the proportion of an asset’s true range for a day to its average true range.
Exploring Volatility Ratios
The volatility ratio helps investors track a stock’s price fluctuations. While standard deviation is commonly used to measure volatility, forming the basis for trading channels like Bollinger Bands, envelope channels help identify trading signals by revealing price ranges and patterns. Historical volatility, another valuable trendline, can be used to follow such fluctuations.
Jack Schwager introduced the concept of a volatility ratio in the book Technical Analysis to further enhance the analysis of price volatility. The method of calculation for the volatility ratio may vary across different methodologies.
Calculating the Volatility Ratio
Schwager’s method for calculating the volatility ratio builds upon Welles Wilder’s true range concept:
VR = TTR / ATR
where:
VR = Volatility Ratio
TTR = Today's True Range
Today's True Range = Max - Min
Max = Today's High (or Yesterday's Close if higher)
Min = Today's Low (or Yesterday's Close if lower)
ATR = Average True Range of the Past N-Day Period
Alternative calculations for the volatility ratio include:
- **Absolute Value of TTR over ATR:
VR = |TTR| / ATR
where:
|TTR| = Absolute Value of TTR (considering various max/min combinations)
TH = Today's High
TL = Today's Low
YC = Yesterday's Close
- Absolute Value of TTR over EMA:
VR = |TTR| / EMA
where:
EMA = Exponential Moving Average of the True Range for the Past N-Day Period
Volatility Ratio Signals
Investors and traders use the volatility ratio to detect patterns and monitor volatility. This ratio is typically displayed as a single line on a technical chart, either as an overlay or a separate panel.
A higher volatility ratio signals significant price fluctuations within the trading day, indicative of disturbances or developments impacting the security’s price. Such volatility could lead to a new trend in either a positive or negative direction. Traders monitor the volatility ratio along with other trading patterns to confirm trading signals and investment decisions.
Related Terms: True Range, Average True Range, Standard Deviation, Bollinger Bands, Historical Volatility.
References
- Jack D. Schwager. Technical Analysis, Page 632. John Wiley & Sons, Inc, 1996.
