FX Volatility Part 2 - Introducing the Volatility Cloud Indicator
Summary
The Volatility Cloud indicator utilizes 24-hour forex volatility maps to project potential amplitudes of hourly price movements. The concept builds on the volatility study presented in Part 1 of the series (Analysis Concepts #22 April 19, 2011). Multiple copies of the indicator may be inserted into the same chart in order to view historical volatility for different time periods simultaneously and to display multiple volatility bands centered on the opening price of each bar. A TradeStation workspace and ELD file for the custom analysis techniques are attached to this report so that you can better understand how the content of this paper may be used in trading.
Figure 1: EURUSD with FX Volatility Cloud Indicator and 24-Hour Volatility Map Indicator
Analysis Techniques
A) 24-Hour Volatility Map
The 24-Hour Volatility Map is displayed in sub-graph 2 of the chart in the attached workspace and provides a frame of reference for the Volatility Cloud indicator. The concept was first introduced in study form in Part 1 of the series. Each line indicates how the hourly volatility has performed over a specified time period. The indicator is centered on the last bar on the chart and displays a total of 24 hours of data: 12 hours before and 12 hours after the last bar on the chart. Each data point is the standard deviation of hourly ranges, from high to low.
Multiple copies of the indicator may be inserted into the same chart window in order to view the historical volatility data for different time periods. In Figure 2 below, two copies are inserted to view the volatility maps for the last five years (see Cyan line below) and year to date (see dark blue line below) with the study end date being March 31, 2011.
Figure 2: 24-Hour Volatility Map Indicator
B) Volatility Cloud
The Volatility Cloud is displayed directly on the symbol and builds on the information gathered by the 24-Hour Volatility Map indicator. This indicator is also centered on the last bar of the chart, with 12 hours of data displayed before and after the last bar. The bands correspond to a specified number of standard deviations away from the opening price of each bar, derived from the historical volatility data from the user-defined time period.
Figure 3: EURUSD Chart with the Volatility Cloud Indicator
Multiple copies of this indicator may also be inserted into the same chart window in order to see the historical volatility bands for different time periods and with different standard deviations. In Figure 3 above, two copies are inserted in order to display the Volatility Cloud covering five years of data with four standard deviations (see Cyan volatility bands above) and the Volatility Cloud covering the year-to-date data with two standard deviations (see dark blue volatility bands above).
In order to display the cloud-like plot (shaded area), simply type "True" for the PlotCloud input (see Table 1 below). When this particular input is set to False, only the boundaries of the cloud will be displayed
Inputs
The inputs for the 24-Hour Volatility Map are the same as the ones for the Volatility Cloud, except for the PlotCloud input, which is only used for the Volatility Cloud. Table 1 below provides a general description of each input. Naturally, the values of the inputs for the two indicators do not necessarily need to be symmetric, meaning that different values for the inputs may be chosen for the 24-Hour Volatility Map versus the input values for the Volatility Cloud.
| Input Name | Input Description |
|---|---|
| StudyStartDate | Start date for the volatility data in EasyLanguage® date format YYYMMDD (e.g. 1110101 for January 01, 2011). |
| StudyEndDate | End date for the volatility data in EasyLanguage date format. |
| DisplayColor | Plot Color. |
| PlotCloud | True/False input used to display shaded area of the Volatility Cloud. |
Formatting
A few precautions need to be addressed before inserting the indicators in order for them to display properly. For instance, space has to be made available to the right of the chart. In order to create additional space, right-click in the chart, select Format Window, and type "12" next to "Space to the Right" in the General tab (see Figure 4 below).
Figure 4: Format Window Dialog Window
Also, enough data needs to be loaded into the chart to cover the time period specified in the Inputs tab. The indicators will otherwise be misleading, since they would only reflect the data that is available in the chart even if the inputs suggest a longer time period. Be careful, however, to have a study end date that is before the current date, otherwise the indicators may not display due to the recurring lengthy calculations.
Moreover, if bars or candlesticks are used as the bar type, the weight of the bars or Wicks might need to be adjusted (see Figure 5 below) in order to see the price action in the midst of the Volatility Cloud. Lastly, allow time for the different indicators to load, especially if you are using multiple copies of the indicators in the same chart window with a long look-back period. It may take several minutes to display the data initially.
Figure 5: Format Symbol Dialog Window
Analysis
Numerous interpretations may be explored with the indicators described in this paper. The following paragraphs will highlight a sample of such possible interpretations.
Different statistical studies may be derived from the Volatility Cloud study.
- For example, what happens to the security n hours after the price penetrates the second standard deviation band? From Figure 6 below, anecdotal evidence suggests that mean reversion can take place within a few bars.
- Also, what happens to the security n hours after the price penetrates a large number of standard deviations, e.g., four standard deviations? From Figure 7 below, anecdotal evidence suggests that the security may continue to trend once a certain number of standard deviations are penetrated before resuming its mean-reversion tendency.
Figure 6: EURUSD Chart with Historical Volatility Cloud from March 24 to March 31, 2011
Figure 7: NZDJPY Chart with Historical Volatility Cloud on March 16, 2011
Note: The Historical Volatility Clouds in Figures 6 and 7 are a modified version of the Volatility Cloud, which will be made available during the upcoming Analysis Concepts – Behind the Scenes online event.
- Different strategies may be built around the Volatility Cloud and the 24-Hour Volatility Map indicators. For instance, buy and sell-short signals could be generated based on the forex pair penetrating a dynamic number of hourly standard deviations. The number of standard deviations would increase when the most volatile period of a 24-hour period is encountered, while the number would decrease when the least volatile period is experienced. Figure 8 shows such sample strategy trades, whereas Figure 9 shows the Equity Curve Line for such a strategy on GBPUSD.
Figure 8: Volatility Cloud Strategy Sample Trades on GBPUSD
Figure 9: Volatility Cloud Strategy Equity Curve for GBPUSD
- Additional indicators may be utilized while displaying the Volatility Cloud, especially since it does not take up much real estate within the chart. This is to say that you may want to use the Volatility Cloud to complement existing studies that are or are not based on volatility (see Figure 10 below).
Figure 10: USDJPY Chart with Various Analysis Techniques, Including the Volatility Cloud Indicator
Conclusion
The different indicators presented in the paper not only build on the concepts presented in Part 1 of the series but also open the door to a multitude of additional possible uses. A key advantage of these tools is the fact that the indicators combine all data specified in the user-defined time period versus having a rolling time period, which is the common approach for other indicators. The Volatility Cloud and the 24-Hour Volatility Map can be combined with other indicators, used independently to help generate statistical studies, or incorporated in trading strategies. Future Analysis Concepts papers and online events may explore such possibilities.
Past performance is not indicative of future results. Forex trading is one of the riskiest forms of investment available in the financial markets and suitable for sophisticated individuals and institutions. The possibility exists that you could sustain a substantial loss of funds and therefore you should not invest money that you cannot afford to lose.
