Chapter 14

Estimating Volatility

In This Chapter

Introducing volatility

Doing some volatility calculations

Getting the hang of Bollinger bands

Focusing on volatility breakout as a trading tool

Volatility is a measure of price variation, either the total movement between low and high over some fixed period of time or a variation away from a central measure, like an average. Both concepts of volatility are valid and useful. The higher the volatility, the higher the risk.

A change in volatility implies a change in the expected price range to come. A volatile security offers a wide range of possible outcomes. A nonvolatile security delivers a narrower and thus more predictable range of outcomes. The main reason to keep an eye on volatility is to adjust your profit targets and your stop-loss to reflect the changing probability of gain or loss.

In this chapter, I describe three ways you can measure volatility, and discuss their virtues and drawbacks. Then I describe the most popular way traders incorporate consideration of volatility into their trading plans — the Bollinger band. I also introduce another kind of band — the average true range band.

Catching a Slippery Concept

Volatility is a concept that can easily slip through your fingers if you aren’t careful. Just about everybody uses the word volatility incorrectly from a statistician’s viewpoint — and even statisticians squabble over definitions. To the mathematically inclined trader, volatility usually refers to the standard ...

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