Volatility Indicators: Bollinger Bands & ATR

Volatility indicators play a crucial role in helping traders understand market fluctuations and price behaviour. Two of the most widely used volatility indicators are Bollinger Bands and ATR (Average True Range). While both indicators measure volatility, they do so in different ways and serve unique purposes in a trader's toolkit.

In this article, we’ll explore how Bollinger Bands and ATR work, how traders interpret them, and how they can be used to create more informed and effective trading strategies.

Bollinger Bands: Measuring Volatility with a Dynamic Range

Bollinger Bands are one of the most popular technical indicators for measuring market volatility. Developed by John Bollinger in the 1980s, Bollinger Bands consist of three lines:

• Middle Band: A 20-period Simple Moving Average (SMA).
• Upper Band: Two standard deviations above the middle band.
• Lower Band: Two standard deviations below the middle band.

Bollinger Bands expand and contracts based on the market’s volatility. When volatility is high, the bands widen, and when volatility is low, the bands contract.

How Bollinger Bands Work

Bollinger Bands create a dynamic range that captures the majority of price movements. The width of the bands changes in response to the market’s volatility. For example, the bands expand during periods of high volatility, such as earnings reports or major news events. Conversely, during periods of low volatility, they contract.

Image Courtesy: Tradingview

Interpreting Bollinger Bands

There are several ways to interpret and use Bollinger Bands:

1. Overbought and Oversold Conditions

• Overbought: When the price touches or moves above the upper band, it suggests that the market may be overbought and due for a correction.
  

• Oversold: When the price touches or moves below the lower band, it signals that the market may be oversold and a rebound could be near.
  

2. Bollinger Band Squeeze

A Bollinger Band squeeze occurs when the bands contract due to low volatility. This often signals that a significant price move is imminent. Traders watch for a breakout in either direction as the bands expand following a squeeze.

3. Bollinger Band Breakouts

A breakout happens when the price moves outside the upper or lower band. However, breakouts are not necessarily signals to buy or sell. Instead, they indicate increased volatility. Traders often wait for confirmation from other indicators before acting on a breakout.

ATR (Average True Range): Measuring the Strength of Volatility

The Average True Range (ATR) is another widely used volatility indicator, but instead of using price ranges like Bollinger Bands, ATR measures the average price range over a specified number of periods. The ATR helps traders determine the degree of price movement and volatility of a security, regardless of its trend direction.

Developed by J. Welles Wilder, ATR is particularly valuable for traders who want to measure market volatility and adjust their stop-loss levels accordingly.

How ATR Works

The True Range (TR) is the greatest of the following three:

1. The difference between the current period’s high and low.
   
2. The difference between the previous period’s close and the current period’s high.
   
3. The difference between the previous period’s close and the current period’s low.
   

The ATR is the moving average of the True Range over a specified period (typically 14 periods). ATR reflects the degree of volatility, but unlike Bollinger Bands, it doesn’t indicate whether the price is trending upward or downward.

Image Courtesy: Tradingview

Interpreting ATR

The ATR is a simple yet powerful tool for gauging volatility. Here’s how traders use it:

1. High ATR Readings

A high ATR reading indicates increased volatility, meaning that the price is moving in larger ranges. This is common during periods of high market uncertainty, such as earnings releases, geopolitical events, or economic data announcements.

2. Low ATR Readings

A low ATR reading suggests low volatility and more stable price action. This often occurs when the market is in a consolidation phase or is moving sideways.

3. Setting Stop-Loss Levels

One of the most practical uses of ATR is in setting stop-loss levels. Traders can use the ATR to set wider stop-losses during periods of high volatility to avoid being stopped out by normal price fluctuations. Conversely, during low-volatility periods, traders may tighten their stop-losses to lock in profits.

How Traders Use Bollinger Bands and ATR Together

While Bollinger Bands and ATR both measure volatility, they can complement each other when used in tandem. Here’s how traders combine the two:

1. Confirming Breakouts

Traders can use Bollinger Bands to spot potential breakouts and ATR to confirm the strength of the move. For example, if the price breaks above the upper Bollinger Band and the ATR rises, it confirms that the breakout is accompanied by strong volatility and is likely to continue.

2. Volatility-Based Position Sizing

Both Bollinger Bands and ATR can be used to adjust position sizing based on volatility. For example, during periods of high volatility (wide Bollinger Bands or high ATR), traders might reduce their position size to limit risk. Conversely, during low volatility (narrow bands or low ATR), they might increase their position size.

3. Setting Stop-Losses

Traders often use ATR to set stop-loss levels based on volatility. For example, if the ATR is high, traders may set a stop-loss farther from the entry price to avoid being prematurely stopped out by price swings. Bollinger Bands can also help identify support and resistance levels for setting stops, with traders placing stops just outside the bands.

Example: Using Bollinger Bands and ATR in Infosys

Image Courtesy: Tradingview

Let’s take Infosys as an example. Suppose the price has been moving within a tight range, and the Bollinger Bands have contracted, signalling a squeeze. At the same time, the ATR is low, confirming that volatility is minimal. A trader might expect a breakout, so they monitor the price closely. Once the price breaks above the upper Bollinger Band and the ATR begins to rise, this confirms the breakout is backed by increased volatility, signalling a potential buying opportunity.

Adjusting Settings for Different Strategies

Both Bollinger Bands and ATR are customisable, allowing traders to adjust the settings based on their trading style:

Bollinger Bands Settings

• Short-term traders: May use a shorter period for the middle band (e.g., 10-period SMA) to get more sensitive signals.
  
• Long-term traders: Prefer the standard 20-period SMA or longer periods to smooth out price action and avoid false signals.

ATR Settings

• Short-term traders: May use a shorter period (e.g., 7 or 9 periods) to capture quick shifts in volatility.
  
• Long-term traders: Typically stick to the standard 14-period ATR for a more stable measure of volatility over time.
  

Common Mistakes to Avoid

While both Bollinger Bands and ATR are powerful tools, traders should be aware of the following pitfalls:

1. Overreacting to Breakouts

A breakout above or below the Bollinger Bands doesn’t necessarily mean a strong trend will follow. Traders should look for confirmation from other indicators, like ATR, to ensure that the breakout is backed by strong volatility.

2. Misinterpreting Low ATR

A low ATR doesn’t mean the market is about to reverse. It may simply indicate a period of consolidation or low volatility, and traders should wait for other signals before entering a trade.

3. Ignoring Market Context

Both Bollinger Bands and ATR are most effective when used in the context of the broader market. Traders should consider factors like overall market sentiment, news events, and economic data when interpreting volatility indicators.

Conclusion

Both Bollinger Bands and ATR (Average True Range) are essential tools for understanding market volatility. While Bollinger Bands provide a dynamic range for interpreting price action and spotting breakouts, ATR offers a more direct measurement of price movement strength. Together, these indicators help traders gauge volatility, set stop-loss levels, and make more informed decisions.

In the next chapter, we’ll explore two important tools: Pivot Points, which help traders identify potential support and resistance levels, and Trendlines, which assist in determining the direction of a trend.