For traders and investors aiming to initiate a new position in the market or close an existing trade, risks are as important as returns. The volatility in an asset’s price is a key indicator of the risks involved. With the volatility ratio, it is easier to assess the price patterns and evaluate the possibility of breakouts.

In this article, we delve into the meaning of the volatility ratio, its significance, the volatility ratio formula, its role, limitations and more.

The volatility ratio is a technical indicator used to measure how much the price of a stock, security or any other asset moves. In technical analysis, we have different types of ratios to measure the volatility of an asset’s price. However, the most commonly used volatility ratio involves comparing an asset’s price changes with its average true range (ATR).

As you may have gathered from the meaning of the volatility ratio, it helps you evaluate how much the price moves. This is a direct indication of an asset’s risk. By assessing this ratio before you invest in the market, place a trading order or close an existing position, you can be prepared for possible price fluctuations and set your stop-loss orders accordingly.

Also read: What is a current ratio

• The meaning of the volatility ratio is simple; it tells you how volatile the price of an asset has been relative to its historical volatility.
• The volatility ratio formula compares an asset’s current volatility with its recent price fluctuations.
• A high volatility ratio indicates an increase in the volatility of the asset’s price, while a low ratio may indicate a period of price consolidation.

To understand how the volatility ratio works, let us first discuss the concept of volatility in the financial markets. In the simplest terms, volatility is the change or fluctuation in the price of an asset. It can be classified as realised volatility or implied volatility.

Realised volatility measures the actual historical price fluctuations in an asset. This is why it is also known as historical volatility. Implied volatility, on the other hand, is a measure of how much the market expects an asset’s price to change over time. Both aspects influence your trading decisions.

However, the volatility ratio typically uses concrete historical data rather than the market’s assessment of future volatility. It compares the current price change in a stock or security with its price change over a given period. This will tell you if the asset’s price is currently more or less volatile than its historical behaviour.

Also read: Current Ratio

To better understand how this ratio works, let us check out the formula for the volatility ratio and how to calculate this metric using different data points. Typically, you can use any one of the following two formulas for the volatility ratio calculation.
 

• Jack Schwager’s formula
  The first is the formula introduced by Jack Schwager. It uses the current price range and the average price range of an asset. Check out this volatility ratio formula below:
  Volatility ratio = Today’s true range ÷ Average true range
  Here, the average true range is calculated for n periods, which may be based on the trader’s discretion and requirements. Today’s true range is the difference between the maximum and the minimum price of an asset. It is calculated as shown below:

Today’s true range = Maximum (today’s high, yesterday’s close) — Minimum (today’s low, yesterday’s close)
 

• Alternative formula
  Another volatility ratio formula commonly used involves the use of the exponential moving average instead of the ATR. This is the formula:
  Volatility ratio = Today’s true range ÷ Exponential moving average
  Here, the EMA is the moving average of the ATR over n days, as chosen by the trader.

Also read: Cash Ratio

Knowing the meaning of the volatility ratio and its calculation is important, but you also need to know which signals to look for practically. In price action charts used in technical analysis, the volatility ratio is plotted as a standalone single line or as an overlay alongside the asset’s price.

If the signals generated by the ratio are high (or substantial), it may indicate one of two things. Either the asset’s price is strongly trending in one direction, or it is fluctuating widely without any specific trend in place. Both types of volatility may show up as high signals on the price action chart, but they mean different things for traders and investors. If a new or strong trend is imminent, it may be a sign to enter new positions. If the volatility is not trending but significant, it may be useful for swing traders and intraday traders.

The volatility ratio is a vital indicator for traders and investors because it signifies the current market’s state relative to its recent history. It gives you insights into potential price breakouts, trend reversals or price consolidations. A high volatility ratio signifies increased market activity and often indicates that large price movements are due or established patterns may be broken.

Conversely, a low volatility ratio tells you that the market is in a phase of consolidation or reduced activity. This may also signify a potential buildup of interest before a breakout happens. Or, it may be a temporary lull in trading. You can make use of these low-volatile phases to reassess your strategies and prepare for future price fluctuations.

The changes in the volatility ratio over time can give you insights into market cycles and help you identify periods of expansion and contraction in price movements. This, in turn, can be instrumental in helping you decide entry and exit points, adjust your position sizes and manage risk.

The mathematics driving the volatility ratio involves comparing the current price action of an asset with its historical volatility. At its core, the calculation centres around comparing two main components: the day’s trading range and the average true range. As the volatility ratio formula shows you, the metric is calculated by dividing the day’s trading range by the ATR.

The calculation accounts for percentage changes rather than defining the absolute price changes. This makes it easier to compare fluctuations across different price levels and periods. That said, the mathematics behind the calculation depends on the volatility ratio formula that you use.

The volatility ratio is crucial for defining an effective risk management strategy when you trade in the financial markets. More specifically, this ratio can be pivotal for managing risk in two key ways, as outlined below:

Volatility ratio as a risk indicator

You can use the volatility ratio to measure the potential risk in a new trade. By checking how much risk is involved, you can decide how much capital you are willing to risk, which price points to set as the stop-loss limits and what the ideal position size for your trade will be. In short, you can use the ratio to align your position with your risk tolerance limit.

Using the volatility ratio for portfolio diversification

One of the most effective ways to diversify your portfolio is to include assets with varying risk profiles. By comparing the volatility ratio of different assets, you can identify which of them carry low, moderate and high levels of risk. You can then compare the potential returns from different assets and diversify across various risk-return categories.

Although the volatility ratio is commonly used, many traders have various misconceptions about what it indicates and how it can be used. Let us explore some prominent myths about this metric.

Debunking volatility ratio myths

Misconceptions about directional predictions

Many traders mistakenly think the volatility ratio predicts the future price direction. However, it only measures the current volatility relative to the historical volatility. High ratio values can precede strong moves in either direction, while low volatility does not guarantee future price stability.

Misinterpretation of trading signals

Some traders assume that a high volatility ratio always indicates a good trading opportunity. However, extremely high levels of volatility may also be a sign of unstable market conditions which increase the risk significantly. So, a high ratio should be a sign to carefully analyse the market rather than to take immediate action.

Interchangeability

There is also a misconception that the volatility ratio is interchangeable with other measures like the standard deviation or asset beta. While these measures may be related, they evaluate different aspects of volatility. The ratio specifically compares current volatility with recent price fluctuations and gives insights into short-term market dynamics.

The answer to what a ‘good’ volatility ratio is can be highly subjective. It depends on many factors like the specific trading strategy you want to use, the asset’s historical price patterns, the reason for the volatility and broader market dynamics. Generally, if you are looking for a fairly stable scenario, a volatility ratio between 0.5 and 1.5 may be suitable.

Values above this range may indicate larger price fluctuations, which could be leveraged to your advantage. That said, the decision about which values constitute high and low ratios is based greatly on what levels are ‘normal’ for the asset in question.

The volatility ratio is a useful indicator to gauge the risk associated with a potential trade. However, it also comes with some limitations such as the following:

Short-term focus

The volatility ratio primarily captures short-term market movements. It typically overlooks longer-term trends and fundamental factors. This narrow time frame can lead to false signals in markets with significant but infrequent price movements.

Sensitivity to outliers

Extreme price movements can disproportionately affect the volatility ratio and skew its interpretation. A single day of unusually high volatility can impact the ratio greatly and result in possibly misleading signals that may not reflect the price trend accurately.

This brings our guide on the volatility ratio, its meaning and calculation. While it offers insights into short-term market behaviour, it is crucial to remember that the ratio has some limitations too.

If you are investing in mutual funds, understanding the volatility ratio can offer additional context for assessing the risk and performance of a fund. When you compare mutual funds, for instance, consider their historical volatility ratios along with other metrics to get a more comprehensive view of their risk-return profiles.

To find and invest in the mutual fund schemes suitable for your portfolio, check out the 1,000+ funds available on the Bajaj Finserv Mutual Funds Platform. You can also use the mutual fund calculator on this platform to get a clearer picture of how your investments may perform over time.