Market volatility measures how much the value of an asset goes up and down over a certain period of time.
This could be a stock, a forex pair, an index, or any other financial assets available through CFD trading.
In this guide, we explain the meaning of market volatility, and why it matters to your trading.
We give you some simple tools to help you identify volatile market conditions and so improve your chance of trading success.
What is the meaning of market volatility?
Volatility describes the rollercoaster of the financial world.
It measures how much the price of something goes up and down over a certain period of time.
In the case of forex, it measures how much one currency changes in value compared to another.
On the stock market, volatility describes how much the price of a stock changes in a set period of time.
It’s the distance the stock price moves in a day or week, or, if you like, how big or small the candlesticks are.
A volatile market experiences frequent and sizable price swings, both upwards and downwards.
What causes market volatility?
Volatility in the stock market or in forex trading can be caused by a variety of factors. These may include:
1. Economic data and news
Major economic reports, such as GDP growth, employment figures, inflation rates, and interest rate announcements, can cause significant volatility. Positive data can boost investor confidence, driving prices up, while negative reports can lead to sell-offs.
2. Corporate earnings reports
Volatility in the stock market can be caused by companies releasing quarterly earnings reports. If the results differ from market expectations, it can trigger volatility. Better-than-expected earnings can lead to a surge in the stock price, while disappointing results may cause it to drop.
3. Geopolitical events
Global events like wars, political instability, or trade disputes can create uncertainty in the markets, causing investors to react with caution. This often leads to significant fluctuations in stock prices.
4. Market sentiment and investor behaviour
Market sentiment—how investors feel about the stock market or a specific forex pair—can be a major driver of volatility. Fear, greed, and market speculation can cause prices to swing dramatically as investors react to perceived opportunities or risks.
5. Interest rate changes
Central banks, such as the US Federal Reserve or the Reserve Bank of Australia, set interest rates that influence borrowing costs and overall economic activity. Rate hikes or cuts often lead to market volatility as investors adjust their expectations.
6. Liquidity and market depth
When there is low liquidity, meaning there are fewer buyers and sellers in the market, assets often become more volatile. Small trades can have a larger impact on the price, leading to wider price swings. This is the reason why exotic forex pairs are far more volatile than the more stable major pairs.
7. Global crises
Events like the COVID-19 pandemic or financial crises can cause extreme volatility as markets react to uncertainty and increased risk. In such times, panic selling and rapid market corrections are common.
8. Speculation and algorithmic trading
High-frequency trading and algorithmic trading systems, which make trades based on pre-programmed criteria, can contribute to volatility, particularly in times of market stress. These systems can exacerbate price swings by triggering large, rapid transactions.
All of these factors can create uncertainty in the market, leading to volatility in the stock market and forex market alike.
While volatility can be nerve-wracking for traders, it’s actually a normal part of the market cycle.
The market cycle describes how price action often moves in a predictable pattern, as this diagram illustrates:
Why market volatility is a trader’s friend
Traders need the markets to move to generate trading opportunities, so they often prefer highly volatile conditions.
If the markets are flat (i.e. low volatility) it can lead to conditions where traders are frustrated by the lack of movement.
However, higher volatility can also mean higher risk, and the need to get in and out of trades more quickly, so highly volatile conditions are not always preferable, especially for beginner traders.
Best volatility for beginner traders
Some financial instruments are quite stable, with only gentle price movements up and down over a day or a week. These are known as stable assets.
The price of other financial assets can move quite violently up and down, so they are known as volatile assets.
For example, cryptocurrency is known to be a very volatile asset, as there can be a great deal of price movement in a short space of time.
The chart below shows hourly Bitcoin price movement over just seven trading days.
As you can see from this chart, the price of Bitcoin ranged from around USD $64,000 to over USD $70,000 in the space of a few trading days.
Such volatility is not recommended for beginners!
How is volatility measured?
Volatility is measurable, and we can plot it on a price chart.
This enables us to see how volatile one asset is compared to another.
We measure volatility in percentage terms, by taking the distance from the asset’s low value of the day to its highest peak of the day, compared to the asset’s price.
For example, if a $1 asset moves 10c from its highest price point to its lowest price point in one day, its volatility would be 10%, because its price has moved a tenth of its overall value in one day.
Standard deviation means the average amount an asset’s value differs from the mean over a period of time.
Standard deviation is the most common way to measure market volatility, and traders often use Bollinger Bands to analyse standard deviation.
Using Bollinger Bands to measure volatility
Traders use an indicator tool called Bollinger Bands to measure volatility and look at how prices change over time.
The standard deviation is shown by the width of the Bollinger Bands. The wider the Bollinger Bands, the more volatile an asset’s price is within the given period.
Bollinger Bands have three lines: the simple moving average (SMA) in the middle, and then two bands placed one standard deviation above and below the SMA.
The SMA is like a smooth version of the asset’s past prices, but it doesn’t react quickly to change.
The outer Bollinger Bands move along with the asset’s price change, to show how much the price is deviating from the average:
- If the Bollinger Bands are wide, it means the price is changing a lot
- If they’re narrow, it means the price isn’t changing much, so there is little volatility
Here is an example of the Bollinger Bands expanding when volatility increases on USD/THB.
You can see at the left of the chart example, the Bollinger Bands are closer together.
Later, when USD/THB becomes more volatile, the bands expand to become relatively wide. Once volatility begins to decrease, the bands start to move closer together again.
Remember that Bollinger Bands are a ‘lagging’ indicator, meaning that it will take time for the bands to compress after a period of volatility.
This is because Bollinger Bands take the average price movement over the last 20 candlesticks to calculate the position of the bands.
Using ATR to measure volatility
The Average True Range (ATR) indicator is also a useful tool for measuring volatility.
The ATR measures the price movement over a time period and gives you an average.
For example, the ATR could measure the average price of the last 50 candles. If the ATR was 20, it would mean the average price movement was 20 pips over the last 50 candles.
By tracking the increases or decreases in the ATR over time, you can see the increases or decreases in volatility in an instrument.
Here is another example using ATR instead of Bollinger Bands to track the increase in volatility:
Additional indicators to measure volatility
Bollinger Bands and the ATR indicator are not the only indicators that can be used to measure volatility.
However, they are the indicators that I prefer to use in my trading, and they are my MarketMates colleague Sam’s favourites too.
It’s for this reason that we are recommending them to you.
If you’d like to explore further options to measure volatility on your trading charts, these are some of the other options available for you to use:
- Keltner Channels (popular with those traders using MT4 and MT5 as their trading platform)
- Chaikin Volatility indicator (which measures volatility as a widening of the gap between a security’s highest and lowest price)
- the Twiggs Volatility indicator (for those of you who use Incredible Charts as your charting program)
The Market Volatility Index
For stock market traders, the Market Volatility Index (VIX), is often referred to as the ‘fear gauge’ or ‘fear index.’
It is a popular measure of the stock market’s expected volatility over the next 30 days.
It is calculated by the Chicago Board Options Exchange (CBOE) and is based on the prices of options on the S&P 500 index.
How the VIX works:
The VIX reflects investors’ expectations for future volatility.
When the VIX is high, it signals that investors expect significant price swings in the market, indicating fear or uncertainty.
Conversely, a low VIX suggests that markets are expected to be stable and that investor confidence is relatively high.
The VIX rises during times of market turmoil, such as economic crises, geopolitical tensions, or sudden market sell-offs.
This is because investors rush to buy options to protect their portfolios, driving up the price of these options and thus the VIX index itself.
What VIX values mean
The VIX doesn’t have a fixed number range, but its values typically fall between 10 and 80.
Theoretically, there is no upper or lower limit, though it’s rare for the VIX to drop below 10 or rise above 80.
Typical VIX range and their meaning for volatility:
- Below 10: Extremely rare and indicates an unusually calm market.
- 10 to 20: Considered a normal range, reflecting low to moderate volatility.
- 20 to 30: Signals increased volatility, often due to market uncertainty.
- Above 30: Indicates high volatility, often seen during financial crises or major market sell-offs.
During extreme market events, the VIX can spike well above 30, as it did during the 2008 financial crisis and the 2020 COVID-19 market crash.
It’s very rare to see values above 80.
Key points about the VIX:
- High VIX values indicate high market volatility and investor fear
- Low VIX values suggest lower volatility and greater market stability
The VIX is widely used by traders and investors to assess market sentiment.
It is a tool which can be used to warn of potential increased risk during periods of market uncertainty.
It doesn’t predict the direction of the market, but rather the degree of expected volatility.
Why volatility is important to traders
Volatility is crucial because it directly affects trading decisions and strategies.
Here’s why volatility matters:
- Price movement: Higher volatility means prices can change rapidly, providing more trading opportunities.
- Risk management: Higher volatility can lead to larger price swings, increasing the potential for both profits and losses.
- Strategy selection: Different trading strategies perform better depending on the level of volatility.
- Market conditions: Sudden increases in volatility may signal significant news events or changes in investor sentiment.
- Price prediction: Historical volatility patterns may indicate potential breakouts or reversals in the market.
Price volatility is a key factor that traders take into account when deciding to place a trade.
It influences position size, stop-loss placement, entry and exit points, and other trading decisions, depending on your particular strategy.
What is ideal for beginner traders is nice, gentle, movement that goes up and down according to an easily-recognisable pattern.
Unfortunately, trading is rarely that easy or predictable!
What the trader is more likely to encounter is short periods of high volatility, followed by quiet periods with no price movement at all.
This is a market pattern known as ‘quiet sideways,’ indicating a period of price consolidation.
Beginner traders should learn to recognise and adapt to different levels of volatility to improve their trading performance and minimise their trading risk.
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Till next time, happy trading!
Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Britannica Money – the Chaikin Money Flow Indicator https://www.britannica.com/money/chaikin-money-flow-calculation
- Keltner Channel – volatility-based bands. https://www.investopedia.com/terms/k/keltnerchannel
- Incredible Charts – charting software. https://www.incrediblecharts.com/
