Trading Systems and Methods, 6th Edition

CHAPTER 20Advanced Techniques

After price, volatility has the greatest impact on trading, so it is worth spending time understanding how to measure it and how to use it when trading. Those methods cover a wide range. Volatility has already been discussed as part of many indicators. It is used to improve the performance of stop-losses and profit-taking and may confirm a breakout or indicate a regime change. A volatility-adjusted indicator allows many systems to automatically adapt to changing market conditions.

Volatility can be used as a trading filter, avoiding risk when volatility is high, or standing aside when the volatility is low and opportunity is small. It is the key measure of risk and will be the dominant ingredient in structuring a portfolio, covered in Chapters 23 and 24. It is used to size positions and maximize diversification. As systematic programs mature, there seems to be a greater, justifiable concentration on how to include and manage volatility. Here, we will look at it in more detail.

MEASURING VOLATILITY

There are five practical measures of volatility that can be easily used to satisfy the need to show expanding and contracting volatility but are not tied to an underlying price level. The first four measure volatility over the most recent n days, or n bars using price differences or ranges. The last uses returns, a percentage change, which applies to equities and cash markets, but not back-adjusted futures or some split-adjusted stocks. Referring to ...