New Trading Systems and Methods, Fourth Edition

CHAPTER 20

Advanced Techniques

Volatility is an essential ingredient in many calculations, from Wilder's RSI to variable stop-loss points and point-and-figure box sizes. It can be an important filter for a trading system or it can be the main component of a strategy. Although a chart of volatility can look erratic, it is a more consistent and a more predictable component of a price series than the trend. Volatility is the main ingredient in risk; the more volatile the market, the greater the risk. As systematic programs mature, there seems to be a greater, justifiable concentration on how to include and manage volatility.

MEASURING VOLATILITY

In general, the volatility of most price series, whether stocks, financial markets, commodities, or the spread between two series, is directly proportional to the increase and decrease in the price level. Higher prices translate into higher volatility. This price-volatility relationship has been described as lognormal in the stock market, and is similar to a percentage-growth relationship. When you see a chart of the S&P 500 futures price series, the individual daily moves are clearly more volatile as prices peak in January 2000; however, if you plot prices on a semi-log scale, they appear to be very uniform. In Chapter 5's section on point-and-figure charting, it was shown that soybeans increased in volatility at an average rate of 2.38% relative to price, very much the same as a logarithmic increase.

where V(n)_today = today's value ...