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How to use the volatility indicator

The volatility indicator is a popular indicator used by traders, particularly when used alongside the Bollinger Bands (BBs) indicator. In financial terms when a market or stock is referred to as volatile, it suggests that price fluctuates a lot. The cryptocurrency market is generally seen as an extremely volatile market. There are many suggested reasons for cryptocurrencies seeing high volatility.

Low market capitalization

The cryptocurrency market has a very low market cap in comparison to other markets. For example, the London Stock Exchange (LSE) has a market capitalization of $4.6 trillion USD (2018), with the market capitalization of gold standing around $9 trillion USD. Compared to this the cryptocurrency market is very small, with a market capitalization of $530 billion USD (11/12/2020). Due to the market being smaller, capital flowing in and out is quickly impacts the market cap.

For example, if $100 billion USD flows into the cryptocurrency market – this would increase the market cap by 19%, with the influx of capital being shown with increasing prices. However, with the gold market cap being 17 times larger than the cryptocurrency market, the inflow of $100 billion USD would only increase the market cap by 1.1%, with much lower gains. In this case, the increased volatility of the cryptocurrency market would present great reward. Although there is also an increased risk, as a $100 billion USD flow out of the cryptocurrency market would be substantial. Coins would likely see vast red candles if such an event occurred. Due to the higher risk / reward and increased price fluctuation from the lower market cap, volatility is high.

This then brings us towards individual cryptocurrencies themselves. BTC is typically the least volatile cryptocurrency excluding stable coins. The reason for this is due to BTC having a market cap substantially higher than any other cryptocurrency, with a market cap dominance of 63% (11/12/20).

As traders we can benefit from this high volatility. One way to do this is through the use of the cryptocurrency volatility indicator. The cryptocurrency volatility indicator allows us to identify periods of high or low volatility. This can help with the identification of trend breakouts or reversals.

BTC/USD – periods of high volatility, indicated with the volatility indicator.

Using the volatility indicator with formations

Below, there is a clear triangle formation with the BTC/USD pair. There is a downwards trend with an upwards support line, creating a symmetrical triangle. As a triangle nears the end of its formation, the volatility decreases. This is due to a somewhat stalemate between the bulls and bears.

BTC/USD

When placing the long or short position a great way to know future price direction is by looking at the BBs. Below we can see that a positive breakout has occurred. This is confirmed by BTC riding the upper deviation of the BBs. Due to BTC breaking above and riding the upper deviation, this chart would have suggested the placement of a long term long position for BTC. If BTC found support at the 20 day SMA (red line) this would also act as confirmation for the long trade.

BTC/USD

The volatility of the move will depend on how low the volatility indicator currently is. In this example, BTC increased in price from $9000 USD all the way to $12000 USD, seeing around a 37% increase. The large move was due to BTC volatility being at its lowest point since May 2019.

BTC/USD

In the second example below, we can see the trading pair ETC/USD. ETC fell from $9.3 USD towards $3.3 USD. During this move down, as the descending wedge contracted – the volatility levels fell. This indicated that as ETC moved towards $3.5 USD, a breakout was imminent and that ETC was about to move heavily in either direction. 

ETC/USD

As we can see below, like in the first BTC example – ETC broke out positively and was riding the upper deviation, while additionally finding support at the 20 day SMA. Therefore according to the chart with the BBs / volatility trading method, a long position was recommended to be taken.

ETC/USD

Takeaways

As shown in the two examples, the volatility indicator is very useful at identifying when a cryptocurrency is heading towards the end of its formation. From here we can then use the volatility indicator alongside the BBs to determine the direction of the breakout, which can help us determine whether we want to take a long or short position.

AAX offers multiple volatility indicators:

  • Volatility close-to-close
  • Volatility index
  • Volatility O-H-L-C
  • Volatility zero trend close-to-close
  • Chaikin volatility
  • Relative volatility index
  • Historical volatility

Try using each of the indicators and find which one works for you and your personal trading strategy.

Conclusion

The volatility indicator is a handy indicator, although it does not send out buy or sell signals like other indicators (e.g. the MACD). Instead, the indicator helps us to read the market and determine when significant price movements are set to occur. The volatility indicator works very well alongside the BBs and Keltner Channels, although it should never be used by itself – only with other indicators. 

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