Volatility Indicators-Bollinger Bands

Using a volatility chart such as the one developed by OANDA, is a quick way to provide a ‘heads up’ on those instruments which are moving and those which are not, along with any associated anomalies. This in turn tells us where we need to focus our attention, whether we are looking for high, medium or low volatility opportunities, either helping us to get in, to stay in, or indeed to exit a position.

The next logical step is to consider ‘on chart’ volatility. In other words, directly on the trading chart in real time, and one of the easiest ways to do this is by using a volatility trading indicator. This can then provide an analysis of the instrument’s volatility directly. Whilst there are several of these available, the two we are going to look at in detail here, are Bollinger bands and Starc bands.

The first was developed by John Bollinger and his indicator incorporates standard deviation as the primary methodology. By contrast Starc bands were developed by Manning Stoller and they adopt the ATR approach. Whilst both display bands on the chart, many traders wrongly assume they are similar – they are not, and this was one of the reasons I introduced the two concepts of standard deviation and average true range at the beginning of this chapter. I did this in order to explain these two indicators in more detail.

There are several other volatility indicators, which I’m sure have their own advocates and you may have already discovered these for yourself. My own opinion is simply that Bollinger bands and Starc bands are a good place to start as the basis for any volatility analysis. You should find both of these indicators on most good charting packages. Using an indicator to analyze volatility directly on the chart has several inherent benefits.

First, the analysis applies directly to your chart, and hence your trading timeframe. Second, no matter what the timeframe of the binary option, the timeframe of the analysis can be closely matched. Third, any analysis can be applied from 1 minute to 1 month and everything in between. Fourth, it’s fast with no other charts required. Fifth, it can be applied across multiple timeframes for additional analysis.

Finally it’s fast and easy to change instrument and spot other trading opportunities quickly. So let’s start with Bollinger bands.Bollinger bands were developed by John Bollinger as an easy way to display price action in the context of its relationship to the mean. If you recall from the normal distribution chart, here we saw the mean at the peak of the bell curve, with one, two or three standard deviations then applied.

Typically, 2 standard deviations will encompass 95% of price action, and this in essence is what is displayed on the screen using Bollinger bands. Three lines are displayed on the chart, the one in the centre is a simple moving average, usually defaulted to 20 periods, with the two lines on either side denoting 2 standard deviations above and below the mean. In other words,moving standard deviations which then track the price action candle by candle.The example here is from the NinjaTrader platform, and as you can see we have three bands on the chart.

The upper band and the lower band represent the two standard deviations 2 SD, whilst the middle band is the 20 period simple moving average (20 MA), the mean in other words. One of the most important aspects of using Bollinger bands to interpret volatility is what I call the ‘squeeze’ regions, and as you can see we have three such areas on this chart. This is where the upper and lower Bollinger bands have started to revert back to the mean.

Volatility is declining and the price action is entering a congestion phase of relatively low volatility, with the bands then ‘squeezing’ together to form these classical patterns. In squeeze phases, volatility has drained away from the market, which may be good news if the probabilities are in your favor, but not such good news if the probabilities are against you.

But if you are not in the market, it may also present other trading opportunities using some of the more exotic binary option contracts which we will be looking at later in the book. But the key point is this. The squeeze is a simple and clear signal volatility is ebbing away, and one that will be confirmed on the OANDA volatility indicator. Once the squeeze starts, we know consolidation will follow, as we await the breakout and a widening of the bands as volatility increases once again.