Volatility indicators and binary options are a great combination. They can create simple but highly profitable trading strategies. What is even better: two of the strategies which we will teach you can win you a trade without requiring you to predict the direction in which the market will move – trading could not be simpler.
In this article, you will learn:
With this information, you will be able to create your own profitable binary options strategy based on volatility indicators.
Volatility indicators are technical indicators. That means they aggregate the data of past market movements, apply a formula, and display the result in a way that allows traders to quickly and simply understand what is going and what will happen next.
Technical indicators focus solely on price action. That means they ignore all fundamental information about the underlying asset, for examples the earning of a company or the economic prospect of a country. Instead, they analyze what has happened to an assets price in the past and create predictions based on this analysis.
Volatility indicators are a special form of technical indicators. They measure how far an asset strays from its mean directional value. This might sound complicated but it simple:
Volatility indicators measure an asset’s volatility and display it in a way that makes it easy for you to predict what will happen next.
There are two main types of volatility indicators:
Let’s look at examples of both types:
There are many volatility oscillators. The most accurate of them is the Average True Range (ATR). The ATR wants to find out how far an average period of an asset has moved in the past, but it uses a more accurate method of calculation than other indicators.
Other indicators use a fixed formula, for example always subtracting the current period’s high from its low. While this method is accurate, it ignores gaps. Sometimes, the market jumps from one price to another, which creates a gap in the market. Momentum indicators that ignore these gaps paint a distorted picture. The ATR’s main advantage is that it recognizes gaps and factors them into its calculation.
For a detailed explanation of the ATR, please read our article on the ATR. For this article, the important point is that the ATR calculates each period’s true range and then creates an exponentially smoothed moving average.
The result tells you the average true range of the last periods. For example, when the ATR has a value of 0.1, you know that an average period has £0.1 in the past. You can use this value to predict the range of future market movements.
You can also interpret the value in relation to previous values.
Both trends are likely to continue. They create different situations that require different trading strategies, and the ATR helps you to identify which one is right for now.
Bollinger Bands create a price channel around the current market price. The market price’s relation to this price channel helps you predict what will happen next.
The Bollinger Bands’ price channel consists of three lines:
Bollinger Bands predict that the market will stay within the upper and the lower line. The middle line works a barrier that can be a support or a resistance. This means, when the market approaches a line, it is likely to turn around. While it can eventually break the middle line, it is highly unlikely to move past the outer lines.
For traders, Bollinger Bands allow simple predictions. They provide clear indications for a movement’s possible reach and plenty of resistance and support lines that allow for easy trades.
Binary options traders can profit from volatility indicators more than traders of conventional assets. There are two main reasons for this statement:
Traders of conventional assets are unable to win a trade on volatility alone. Stock traders, for example, can use volatility indicators as one factor in the decision-making process, but volatility indicators say little about whether an asset’s price will rise or fall – they only predict that it will go somewhere.
This is unfortunate. Volatility indicators are one of the few types of indicators that can provide clear predictions, but they are insufficient to win stock traders a trade, robbing them of the possibility to create a simple, mathematical strategy.
For binary options traders, however, knowing that the market will go somewhere can be enough to win a trade.
Binary options offer a tool called boundary options. A boundary option defines two target prices in the equal distance of the current market price, one above the current market price and one below it. When the market reaches one of these target prices, you immediately win your binary option.
Boundary options are ideal for momentum indicators. For example, assume that an asset is trading at £100 and that your broker is offering you a boundary option with an expiry of one hour. The target prices are at £100.20 and £99.80.
To predict whether the market can reach either target price, all you have to do is apply the ATR and set the period of your chart to one hour. Now two things can happen:
Depending on your tolerance for risk, you can adapt your strategy. You could wait to invest until the ATR reads twice or three times as much as the distance to both target prices. The longer you wait, the less trading opportunities you find. But you will win a higher percentage of your trades, which can be worth the tradeoff for risk-averse traders.
There are many types of binary options. Often, there are two or more similar types that only differ in the strength of the required movement. The type that requires a stronger movement compensates traders by providing a higher payout.
For example, there are high/low options and ladder options.
Simply put, predicting a stronger movement will get you a higher payout. The problem is, when you predict a too strong movement, you will lose your trade and get no payout at all.
Momentum indicators such as the ATR are the ideal tool to predict how a strong a movement you should predict.
Assume for example, that your strategy predicts an upwards movement for an asset that is trading at £100. If the ATR reads 0.2 for a one-hour chart, and your broker offers you a ladder option with a target price of £100.10 and a payout of 150 percent, you know that there is a good chance that you will win the option. If you correctly predicted an upwards movement, you will likely win your option. Since the payout is twice as high as with a high/low option, most traders would take the chance. If the ATR would read only 0.05, you should trade a high/low option.
In this simple way, momentum indicators can help you to increase your average payout without having to change your basic trading strategy. For serious traders, this gift is impossible to pass up.
Binary options traders can also use volatility indicators to create trading signals. When the market is moving towards a Bollinger Band, for example, you know that it will likely turn around. This is a prediction that you can trade.
Similarly, when the market has broken through the middle Bollinger Band, you know that it is likely to continue its movement until it reaches the outer Bollinger Band. This knowledge provides a clear indication for how far the market will move, which is a prediction you can trade, too.
Other technical indicators allow for similar predictions.
We have already touched on three ways in which you can trade volatility indicators. Now we have to define concrete strategies that you can trade. Let’s take a closer look at how you can trade binary options with volatility indicators.
This strategy is so interesting for this article because it combines the advantages of the two momentum indicators on which we have focused. Those advantages are:
Combined, both indicators provide you with enough information to trade a binary option with a high payout.
When the market has broken through the middle Bollinger Band, it will likely move to the outer Bollinger Band. This prediction alone is enough to trade a high/low option.
This strategy can make you money – but it limits your payouts to high/low options. The ATR can help you to make more money with the same strategy. All you have to do is compare the ATR’s value to the distance of the next Bollinger Band.
Let’s look at an example. Assume you are looking at an hourly chart and that the next Bollinger Band is £0.1 away. The ATR has a value of 0.025. With this knowledge, you could predict that a perfectly straight movement will take the market to the next Bollinger Band in about 4 hours.
There is only one problem: nobody can guarantee you that all periods will point in the same direction. When only one period points in the opposite direction, it will already take longer for the market to reach the Bollinger Band.
To check your prediction, you can switch to a chart with a period of 4 hours. In our example, let’s assume that the ATR reads 0.075 in this chart. That means an average 4-hour period would be insufficient to take the market to next Bollinger Band. You should expect it to take a little more time, probably around five to six hours.
This knowledge helps you to trade a binary option with a higher payout than a high/low option.
This strategy is simple and profitable. Bollinger Bands help you to create signals easily, the ATR makes picking the right option type as simple as comparing a few numbers. You know which movements are within reach, and all you have to do is pick the options type with the highest payout to profit from this movement. The entire process is simple and easy – that is the power of momentum indicators.
We have already touched on this strategy. For traders that want to execute it, we will now explain it in full detail. The process is simple and only requires you to compare a few numbers. Here’s what you do:
This strategy is simple. The only thing you have to figure out is if you want to discount the ATR’s reading. For example, you could require the ATR’s reading to be twice as big as the distance to both target prices of your boundary option before you invest. Try a few discount values, and you will soon find the right strategy for you.
Ladder options can do more than creating high payouts. They can also create very safe trades.
This strategy is simple and easy, but there is a catch. Because it creates secure predictions, these predictions get you a very low payout. When you predict that the market will trade below the highest payout when your ladder option expires, you might only get a payout of 10 or 20 percent.
Low payouts require you to win a high percentage of your trades to make money. Just a few losing trades might already be enough to lose you money at the end of the week. Therefore, you need a tool that can help you to avoid the rare situation in which you would lose even a safe prediction. Bollinger Bands are the ideal technical indicator for this job.
When a target price lies outside of the outer lines of the Bollinger Bands, the market is highly unlikely to reach it. To check your prediction, you can always invest in the target price with the highest payout that is outside the Bollinger Bands.
Of course, Bollinger Bands change with each new period. To use them for your trading strategy, you have to match the period of your chart to the expiry of your binary option. When you think about trading a ladder option with an expiry of one hour, you have to use a one hour chart and invest right when a new period starts. If 30 minutes have passed in the current period, you have to adjust your chart to leave enough time in the current period for your option to expire. You can use a period of two hours, for example.
The beauty of this strategy is that it works without predicting the direction of the market. When a price is outside the reach of the upper Bollinger band, you win your option if the market falls. You are also highly likely to win your option if the market falls. The same applies to a price that is outside the reach of the lower Bollinger Band.
To execute this strategy, you only have to follow these three steps:
You might also think about adding a margin of safety. You can do this by requiring target prices to be a certain distance beyond the Bollinger limits.
Applied correctly, this strategy can find you tenths of trading opportunities every day. You can check each chart every time it creates a new period. If your broker offers ladder options with an expiry of five minutes, for example, you can check the chart every five minutes. If only 50 percent of these checks provide you with a trading opportunity, you will still find six opportunities every hour.
If your broker also offers ladder options with an expiry of 15, 30, 60, 120, and 240 minutes, you can add these charts to your trading strategy, too. Now, you can find even more trading opportunities.
In this way, this strategy can find you many low-risk trading opportunities even if you trade only two or three hours every day. Your profit per trade will be small, but based on so many trades, you can still make a lot of money.
Volatility indicators and binary options are a great combination. Indicators such as Bollinger Bands and the Average True Range (ATR) help you to predict the range of a movement and the direction in which the market is likely to move.
You can combine both indicators to trade highly profitable binary options types, trade boundary options based on the ATR alone, or use Bollinger Bands to trade ladder options. Alternatively, you can also add either indicator to your strategy to avoid bad trades and achieve a higher payout.
Volatility indicators offer hundreds of possible trading strategies. You can choose the one you like best, but you should at least consider adding volatility indicators to your strategy. Volatility is an important characteristic of every market environment, and you should at least keep an eye on it.