Welles Wilder's Volatility Index: A Unique Measure of Price Fluctuation

Gauging Market Volatility with Welles Wilder's Volatility Index

While the Average True Range (ATR) is J. Welles Wilder Jr.'s most famous volatility indicator, he also developed another, lesser-known tool called the Volatility Index. The Volatility Index is a unique measure of volatility that is based on the concept of 'true range' but is calculated in a different way. The Volatility Index is designed to highlight periods of expanding and contracting volatility, which can be a valuable leading indicator of future price movements. The Volatility Index is an oscillator that fluctuates above and below a zero line.

The Volatility Index Calculation

The Volatility Index is calculated by taking a 10-day sum of the 'true range' divided by the 'true range' of 10 days ago. The 'true range' is the greatest of the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close. The result is then multiplied by 100. A reading above 100 indicates that volatility is expanding, while a reading below 100 indicates that volatility is contracting. A reading of 100 means that the volatility is the same as it was 10 days ago.

Trading with the Volatility Index

The Volatility Index can be used in several ways. One way is to use it to anticipate breakouts. A period of low volatility is often followed by a period of high volatility. When the Volatility Index is at a low level, it suggests that the market is in a consolidation phase. A trader can look for a breakout from this consolidation range. A breakout that is accompanied by a rising Volatility Index is more likely to be genuine. For example, if the Volatility Index on ES has been hovering around 50 for several days and then suddenly spikes to 150 as the price breaks out of a trading range, it is a strong signal that a new trend is underway.

The Volatility Index and Trend Reversals

The Volatility Index can also be used to anticipate trend reversals. A sharp increase in the Volatility Index can sometimes signal a blow-off top or a panic bottom. For example, in a strong uptrend, a sudden spike in the Volatility Index to an extreme level can indicate that the trend is exhausted and a reversal is imminent. A trader who sees this could use it as a signal to take profits on a long position. Conversely, in a downtrend, a spike in the Volatility Index can signal a capitulation bottom.

The Volatility Index and Other Indicators

The Volatility Index is best used in conjunction with other indicators. For example, a trader could use the Volatility Index to identify a period of low volatility and then use a trend-following indicator like the ADX to confirm the direction of the breakout. A breakout from a low volatility period is more reliable if the ADX is also rising. Another effective combination is to use the Volatility Index with the RSI. A bearish divergence on the RSI that is accompanied by a rising Volatility Index can be a strong signal of a pending reversal.

While the Volatility Index is not as widely used as the ATR, it offers a unique and valuable perspective on market volatility. By understanding how to interpret the Volatility Index and by combining it with other indicators, experienced traders can gain a deeper understanding of the market's dynamics and make more informed trading decisions.