The misunderstandings and misconceptions between volatility and momentum can lead to expensive trading mistakes and can even result in totally flawed chart and market analysis and trading decisions.
Volatility and momentum are two fundamentally different things and we will explore the differences between the two concepts, how to measure volatility and momentum and how to use them for effective trading decisions.
What is volatility?
Volatility describes how much price fluctuates around a mean. If you would use a moving average and see price going back and forth around the moving average, markets are in a high volatility environment. Furthermore, if candlesticks have relatively long candle shadows, compared to the candle body, it also signals a volatile market.
Thus, volatility is also often referred to as a risk indicator because high price fluctuations can signal indecision in the markets and the powers between buyers and sellers are constantly shifting.
What is momentum?
To a certain degree, momentum is the opposite of volatility. During a high momentum market period, price only moves in one direction and the candlesticks do not have large shadows.
Momentum is often referred to as trend strength. In a ranging market, there is no momentum because price moves back and forth between two boundaries.
The strongest trend, therefore, has little to no volatility and a lot of momentum. A ranging market often has high volatility and low momentum. At the end of trends, you can often see volatility picking up when momentum declines.
“Short term volatility is greatest at turning points and diminishes as a trend becomes established.” – George Soros
How to measure volatility?
There are different trading tools and concepts when it comes to analyzing and measuring volatility. We introduce the 4 most commonly used volatility tools.
ATR – Average true range. The average true range indicator is not a pure volatility indicator but it analyzes candle size and how far price has traveled on average during a given time period. A high ATR reading, therefore, implies that price moves farther and a low ATR shows that price candles are narrowing in size.
Bollinger Bands. Bollinger Bands are probably the most commonly used volatility tool. The outer Bollinger Bands visualize the two times standard deviation of price. Widening Bollinger Bands show, therefore, a high volatility market environment and Bollinger Band that are narrow signal a contracting and low volatility market environment.
Candlestick shape. Often, it can be enough to just look at pure price charts. Candles that are increasing in size and also leave long shadows signal high volatility. On the other hand, candlesticks with no wick and only going into one direction show less volatility.
VIX – Volatility Index. The VIX is used to measure broader market volatility and it is also used to evaluate market sentiment and risk appetite. During higher risk periods, the VIX climbs and investors tend to become more conservative. A low VIX shows a higher risk appetite and less broad market volatility.
How to measure momentum?
The tools and indicators used to measure momentum are very different from the volatility tools and although many traders confuse the two, it is essential to know the trading tools you use to make trading decisions.
RSI – Relative Strength Index. As the name implies, the RSI measures price strength. A high RSI shows that the trend is up and that there are little to no bearish price candles during a given period. The RSI compares the candlesticks (bullish vs. bearish) and the size of candlesticks.
CCI – Commodity Channel Index. The CCI indicator measures how far away price is from a given moving average. Thus, a high CCI shows that price has pulled away from a moving average. A CCI around 0 shows that price has been hovering around the moving average.
Stochastic. Although the Stochastics are often used as range indicators, in its essence it is a momentum indicator. The Stochastic measures how far price has traveled and how close price closes near the top or the bottom of a candlestick. Therefore, do not mistakenly believe that an overbought Stochastic indicator indicates that price will reverse any minute – it might as well just show a strong uptrend.
ADX. The ADX is THE trend strength indicator and it is often used to differentiate between range-bound, weak trends and strong trends. Typically, a reading below 30 signals a range whereas ADX values above 30 show a trend. A “hook” on an ADX can then indicate a potential trend reversal or fading momentum.
Candlesticks. All indicator information is derived from price analysis and, therefore, you can read trend strength from your price action charts only. An uptrend with only bullish candles and little to no candle shadows illustrates a high momentum trend.
How to use volatility
Being able to read the current market volatility is only one part of the equation. Afterwards, the knowledge has to be used to make actual trading decisions.
Especially when it comes to adjusting trade parameters and order placement, volatility is the most important concept. Whereas a trader is better off using wider stop and take profit orders to avoid stop runs and capitalize on the larger market swings during high volatility, a more conservative stop and take profit placement should be applied when volatility is low.
Volatility is also used by professional traders to adjust position size. In a high volatility market, stop loss orders are typically set further away because market swings are greater. A wider stop loss distance means that the absolute number of contracts has to be reduced to achieve the same percentage risk.
How to use momentum
Momentum can be used in many different ways and here are the three most common ones when making trading decisions and analyzing price action.
Identifying trends. Momentum indicators are great when it comes to identifying the transition point from range markets to trending markets. A market in a tight range with a low momentum that suddenly shows increasing candle size into one direction and a rising momentum indicator can foreshadow the creation of a new trend.
Early warning signals and fading trends. During a trend, momentum indicators can signal fading momentum and provide early warning signals about potential trend reversals. A “hook” on a high ADX or divergences on the RSI or CCI can foreshadow potential reversals.
The likelihood of price action events. Momentum information is often used to determine the likelihood of certain events. For example, when the ADX is extremely high and the Stochastics have been in overbought for a long time, it is more likely to see support and resistance levels breaking because momentum is high. When price is in a range and the ADX is below 30 and flat, support and resistance levels tend to hold more often and, at the same time, Stochastics will naturally not stay in overbought/oversold too long.
It is essential to understand the differences between volatility and momentum to make correct trading decisions and to fully understand market moves. Traders who do not understand how to use volatility and momentum information in their trading often find themselves in trades where risk can’t be managed or they enter the markets on the wrong side.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results. The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders