Did you know there is a variation of the Bollinger band indicator that can be very useful to identify the two main cycles of volatility any market goes through? This tool is a great visual aid to tell us if we are in an expansion or contraction phase in volatility.
The indicator I am referring to is the Bollinger band width or BBW line. It essentially looks at the distance between the upper and the lower Bollinger band indicator. This is represented through the orange line in the upper pane in the EUR/USD 4h chart below.
It’s quite simple to eye-ball the chart above and decipher by the orange line alone that one of the most obvious characteristics volatility features is that is cyclical. An easy way to illustrate the cyclical nature of volatility is by the constant peaks & troughs.
Volatility rises and falls. When volatility rises (from some kind of external shock like news or other non-discounted developments) it eventually peaks and moves lower. When volatility starts dropping, it continues to drop until the next trough is found.
These peaks & troughs are a very well known dynamics that as part of the proprietary strategy I teach in my mentor room, we factor in. More on the use of it as a filtering mechanism later, but first, let me explain the secondary indicator overlaid in a yellow area.
You will notice, on top of the BBW line, I add a moving average and two envelopes. This addition serves my strategy really well in order to get a sense of the average volatility seen in the past X periods. We’ll call this the BBW mean area (colored in yellow).
It’s up to the trader to experiment with the periods. This will depend on your trading timeframe and how reactive you’d like this measure to be. For instance, if you trade off the 4h with an interest to capture the average volatility over 1 month, the 100-period is an optimal one.
So, what’s the rule I implement that results in strengthening the robustness of my strategy by accounting for volatility cycles?
When the BBW line in orange is at or below the BBW mean area, it represents an ideal period to look for trades in anticipation of the next expansionary wave in volatility. This is potentially the period of maximum reward as we anticipate the next volatility spike.
Psst! In cryptos this concept works phenomenally well given the volatility cyclicality different Alts exhibit.
When the BBW line is above the mean area, subject to having previously seen a higher peak in the BBW line above the previous one, it communicates that volatility has recently been on an expansionary phase and the risk is that it will keep dropping.
If history is any indication, the next expansion in volatility is unlikely to occur unless volatility first stabilizes. How do we assess that this stabilization has occurred? As a rule of thumb, I want to see the BBW line returning back into the BBW mean area.
The current volatility cycle in the EUR/USD 4h chart offers a very fitting example to illustrate this point. The pair has been knocked down to revisit what’s known as the control line in the main chart, which advertises a potential discount within the technical bullish trend.
However, by observing the BBW line, it shows a major spike in volatility above the previous peak. Besides, the BBW line remains out of whack, well above the BBW mean area. What is the this really communicating in plain sight?
It heralds that it’s quite frankly unlikely that we are going to see a resumption of the uptrend with a renewed pickup in volatility any time soon. When I say ‘any time soon’, I mean until volatility stabilizes. Remember, we must always think in probabilities.
If you deploy a swing-type strategy like myself, what I just described above is huge. Why? Because a key component in our technical read of the markets is to time the entries. Would you prefer to be part of a trend when the BBW line implies volatility has peaked or troughed?
I am personally looking to get in trends on the latter conditions. I know that if my entries are when volatility is well above the BBW mean area, the chances are that I won’t get the explosion of volatility I am after to get the highest reward at the earliest possible time.
I find this BBW concept described adds yet another layer of refinement to my strategy. The main point is that the BBW indicator is a nice fit to help me visually deduce when an entry faces sub-optimal chances of working out based on the story around volatility cycles.