Technical Analysis 101 | Best Volatility Indicators for Crypto Trading
Exploring the ups and downs of cryptocurrencies
Cryptocurrencies have a history of being tremendously volatile. This specific characteristic has made them extremely popular, and convinced people like your neighbor or a friend with limited information on their underlying technology to invest in them.
Bitcoin is one of the most volatile assets in recent times, and in a media environment without a clear consensus on whether the asset is worth a lot or worthless, Bitcoin’s volatility was born. In ordinary trading, the scale of volatility is reduced to much smaller proportions. These smaller forms of volatility might not actually be that obvious when looking at a graph. That’s where indicators come into play.
In trading, volatility is actually a category of indicators used to measure how volatile the price is in a certain period of time, indicating when a market is more volatile and, therefore, when more volume is entering in it.
"When trading cryptocurrencies, volatility isn’t something that you should let go unnoticed. Once you’ve mastered these indicators, you’ll be able to take advantage of long price movements to obtain significantly higher percentage returns on your trades."
Traders love volatility. Volatility moves prices, creating trading opportunities and is usually accompanied with more volume. Markets with little volatility are considered boring and not profitable, and very possibly more illiquid. Also, when the price is more volatile, it’s also less likely to range, thereby creating more room for trending positions (ie. up or down a certain direction, rather than sideways).
The great volatility in cryptocurrencies is very possibly the factor that has attracted so many investors and has, no doubt, driven their price to very high levels in such a small time frame. Be warned, volatility is also known to blow up stop-losses too early, leaving traders out of potentially profitable trades while trading a trend. That's why they are often considered as a double-edged sword.
Bollinger bands is one of the most famous indicators to spot volatility. It is made up of three lines. One simple moving average and two standard deviations, one upper and another lower, with values that can be altered according to the preferences of the trader. Since the bands measure the volatility of a specific market, whenever there is more volatility the bands widen, and contract during less volatile periods.
Strategies involving Bollinger bands are very diverse. They are commonly used along with other types of indicators that provide information unrelated to volatility. In fact, its creator, John Bollinger, suggested to only use Bollinger bands when it is applied to two or three other type of indicators.
The number of indicators you would like to use with the Bollinger bands is up to you, a lot of traders prefer to combine them with other indicators.
One of the ways the Bollinger bands is used is to detect overbought or oversold zones, once the price breaks the upper or lower band. This strategy can be combined with several momentum indicators, such as RSI, Stochastic or by just reading the price and its candlesticks.
A break of the lower band combined with a candle with increasing volume and a hammer shape or a long tail might be interpreted as a buy signal.
As can be seen in Figure 2, a mix of a break of the lower band along with a candle with a long tail (signigying that the demand is rejecting those price levels and driving them up again) plus relatively more volume is interpreted as a buy signal. The Stop-loss would be set below the last swing and the take profit would be hit once the price breaks the upper band.
This indicator measures how widely prices move from their average price. It is plotted by a line that remains stable (unless the market is volatile) and close to 0. When the volatility increases these levels can rise to around 20, which implies a lot of volume and volatility in the market.
This basically provides very similar information to the Bollinger bands. Bollinger bands represent volatility when its bands widen, and give potential buy/sell signals through upper and lower bands breakouts. Standard deviation can help to pinpoint volatility in the market comparing price changes with respect to its average.
The Average True Range (ATR) consists of a line plotted in the bottom of the graph measuring the level of volatility. If it starts rising, there is high volatility in the market and if there's low volatility it remains close to the 0 level.
ATR compares the current price with respect to it's past range (a high and a low in a certain period of time). If the price isn’t within that range, the level of volatility starts rising. However, In the case that it is within the range it will remain close to the 0 level. In essence, the larger the range of the candles, the larger the ATR value.
The ATR has many applications that not every trader knows. Apart from being used to spot volatility in the market, it can help to set a proper stop-loss. Stop loss will depend on the ATR in a way that, if there is more volatility in the market, it will be set further from a price average or the highest price of the range. So, if the ATR is 30, the stop-loss will be set 30 points below the highest point of the range, for example.
This volatility indicator can be used to pinpoint the beginnings of a trend after the price breaks the support of a range, as depicted in Figure 2. In this situation, the range’s resistance has been broken. Just after the breakout, we might wonder if the price will go back to the range, what it called a false breakout, or it will start trending up. Here is where the ATR might be useful.
Of course, given the way that ATR is computed, once the price has broken the range the ATR levels will start rising. However, several spikes in this one will suggest that, after the breakout, volatility and therefore volume are entering into the market, which very possibly will make the price start trending. Then, being able to open a long position at the beginning of the trend.
To wrap up, volatility in cryptocurrencies is especially relevant since they went mainstream due to its high spikes and subsequent profitability in the 2017 bull run. Volatility indicators can be a good indicator to pinpoint when a new trend starts after a period of relatively low price action. We have to be careful with this indicator though. While it can prove invaluable to increase our profits, it can be deadly for stop-losses and trend reversals in the opposite direction of our trade.