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Volatility Indicators And Binary Options – The Guide
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:
- What Are Volatility Indicators?
- Why Use Volatility Indicators For Options?
- Three Strategies For Volatility
With this information, you will be able to create your own profitable binary options strategy based on volatility indicators.
What Are 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:
- When an asset has a high volatility, it strays far from its average direction. An earthquake, for example, has a high volatility. Things were quiet for a long time, and now there is a strong movement that often changes direction. Assets with a high volatility suffer constant earthquakes. They often trade far away from their moving averages and routinely change direction.
- When an asset has a low volatility, it has a strong sense of direction. The earth’s movement around the sun has a low volatility, for example. Assets with a low volatility share this strong sense of direction. Their direction can change over time, but they trade much closer to their moving averages that assets with a higher volatility and change direction much less.
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.
Examples Of Volatility Indicators
There are two main types of volatility indicators:
- Oscillators calculate a value and draw it into a separate chart, usually below the price chart. The current value and its relation to past values allow for interpretations of what traders are currently thinking and for predictions about what will happen next.
- Channels use the volatility to calculate a price channel and draw this channel directly into your main chart. The channel surrounds the current market price and predicts the range in which the market is likely to remain. Channels predict that market that has moved too far from an average are likely to make traders nervous, which will lead them to invest in the opposite direction and bring the market back to its average.
Let’s look at examples of both types:
Example 1: The Average True Range (ATR)
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.
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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.
- If the value has dropped from £0.2 to £0.1, you know that market is losing energy.
- If the value has risen from £0.05, you know that the market is picking up steam.
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.
Example 2: Bollinger Bands
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:
- A moving average as the middle line. The typical value for this moving average is 20 periods. Theoretically, you can use any value you want, but this value has worked best for most traders. When the market is above the middle line, it works as a support line. When the market is below the middle line, it works as a resistance.
- An upper and a lower line based on the standard deviations. Most traders use a value of two times the standard deviation for both lines. The upper line works as a resistance, the lower line as a support.
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.
Why Use Volatility Indicators For Options?
Binary options traders can profit from volatility indicators more than traders of conventional assets. There are two main reasons for this statement:
Some Trades Win On Volatility Alone
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.
Volatility And Boundary Options
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:
- The ATR reads 0.2 or more. In this case, you know that an average period has moved £0.20 or more in the past. Since this would be enough for the market to reach the target price, you know that there is a good chance that you would win the boundary option
- The ATR reads less than 0.2. In this case, you know that an average period would have been insufficient to win your boundary option. If you have reason to believe that the next period will be stronger than average, you might invest anyway, but this trade would be a bad idea based on the momentum indicator.
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.
Traders Can Triple Profits With Volatility Indicators
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.
- High/low options allow you to predict whether the market will trade higher or lower than the current market price when the option expires. If you are right, you get a payout of around 70 to 85 percent.
- Boundary options allow you to predict whether the market will trade higher or lower than a target price. Predicting that the market will trade higher than a target price that is far above the current market price, can get you a payout of up to 1,500 percent. Predicting that the market will trade above a target price that is below the current market price will get you a lower payout, maybe only 20 percent.
Larger Movement Means Higher Payout Potential
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.
Volatility Indicators Can Find New Trades
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.
Three Strategies For Volatility Indicators
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.
Strategy 1: Combining Bollinger Bands With The ATR
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:
- Bollinger Bands can predict how far the market will move,
- The ATR can predict how long it will take the market to get there.
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.
- When the market has broken through the middle Bollinger Band in an upwards direction, you invest in a high option.
- When the market has broken through the middle Bollinger Band in a downwards direction, you invest in a 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.
- If you broker offers you a one touch option with a target price in the distance of £0.05 and an expiry of 4 hours, you know that there is a high chance that you will win this option. The movement is within reach of the Bollinger Bands, and the ATR indicates that the market will move the required £0.05 in less than four hours.
- If your broker offers you a ladder option with a target price £0.05 away from the current market price, the same calculation applies as in our first example.
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.
Strategy 2: Trading The ATR’s Reading With Boundary Options
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:
- You create a price chart with the ATR.
- You set this price chart to a period of 5 minutes.
- Now you compare the ATR’s reading with the boundary option that your broker is offering you for an expiry of five minutes. Two things can happen:
- The ATR’s reading is larger than the distance to both target prices. In this case, you invest.
- The ATR’s reading is smaller than the distance to both target prices. In this case, you do not invest.
- You repeat this process for every expiry that your broker offers you. Match the length of the period of your price chart to the length of the expiry, and if the ATR’s reading is larger than the distance to both target prices, you invest.
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.
Strategy 3: Trading Ladder Options Based On Bollinger Bands And Prices That Are Out Of Reach
Ladder options can do more than creating high payouts. They can also create very safe trades.
- When you predict that the market will trade below a target price that is far above the current market price, you are very likely to win this option.
- When you predict that the market will trade above a target price that is far below the current market price, you are very likely to win this option, too.
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.
Reduce Risk With Bollinger Bands
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.
Trade Volatility Not Prices
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:
- Set the period of your chart to the shortest expiry that your broker offers for ladder option and apply Bollinger bands to the chart.
- Compare the target prices to the Bollinger Bands. Invest in the target price with the highest payout that is outside the reach of the Bollinger Bands.
- Repeat the process for each expiry that your broker offers.
Further Risk Management
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.
3 Volatility Indicators To Help You Trade Effectively
Last updated on February 20th, 2020
The natural rhythm of the market is not only trending and consolidation but we have to also deal with different types of volatility. This is where understanding and using volatility indicators can help you trade more effectively and keep your expectations in check.
Volatile periods in the markets can, in the worst scenario, create wild and sharp swings in the markets which can make them difficult to trade. We often see extreme volatility after certain news releases and world events that are extreme in nature and this type of action is easily seen on the chart.
Volatility can be more subtle which we see during extended runs during trending markets and more muted volatility during the consolidation phase of the market. Each of these types of environments are going to have different types of market approaches that can be used.
- Trending types of systems looking to take advantage of individual swings or longer positions until there is a change in trend
- Breakout systems will take advantage of the volatility that arises when there is a true breakout of a consolidation
- You can utilize a channel trading system which can be trend line channels or some types of bands
- Reversion systems will have you taking positions when markets reach a support or resistance zone the contains the consolidation
Knowing what phase the market is in will assist you in using the “right tool” for the job. You probably don’t want to look for longer term trending plays inside of a low volatility consolidation area. You would be letting positions ride when the reversal takes place which will have detrimental impact on your trading account.
Inside of every charting platform, there are tools called volatility indicators that will help you objectively measure the level of the volatility and it’s important to fully understand the tool you are going to use.
Keep in mind there is no best volatility indicator to use so don’t spend too much time picking and tweaking the indicator. This applies to any market including Forex and Futures. Apply it to your chart using the standard setting and that should help you begin to learn how to see volatility in price action.
Using ADX As A Volatility Indicator
The ADX indicator measures the strength of a trend based on the highs and lows of the price bars over a specified number of bars, typically 14. Generally an ADX crossing of the 20 or 25 levels is considered the beginning of a trend, either an uptrend or a downtrend.
A move down in the ADX is considered to signal the end of a trend. While the ADX is below 20 or 25 the market is usually in a consolidation.
As long as ADX continues to rise, the trend remains strong, but once it starts to turn down the trend is weakening. This chart shows a strong trend in place on the left and as price is showing consolidation periods and no strong price thrusts, the ADX peaks and is s sloping downwards with occasional upturns.
This can objectively show you that the strength of the move has softened and any positions in the price trend direction should be managed closely.
The far right of the chart we see an upturn from below 20 with an upturn in the ADX. This can indicate the volatility has returned to the market and you may want to adapt your trading approach to suit the new reality.
ADX Volatility Indicator Rising And Falling
The ADX has two drawbacks that you must be aware of before thinking you’ve found the holy grail of trading.
- It does not indicate the direction of the trend. For that it’s often combined with the Directional Indicator (+DI and –DI) and as a matter of fact the ADX calculation is based on the DI. It’s easy enough however to determine the trend visually of with the use of a simple moving average or using the typical trending price description.
- As is the case with most trading indicators the ADX is a lagging indicator. It signals the beginning or end of a trend after the fact. With proper risk management however that can still allow us to profit from the bulk of a strong move.
Compare the move of the ADX and the condition of price in the graphic and see what else you can learn from this chart that may apply to your trading.
ATR – Average True Range Indicator
The ATR measures the true range of the specified number of price bars, again typically 14. The true range differs from a simple range in that it includes the close of the prior bar in its calculation.
ATR is a pure volatility measure and does not necessarily indicate a trend. It’s quite possible to have volatile price movement inside a choppy market, as is often the case during an important news event.
The best way to use the ATR is as an indication of a change in the nature of the market. We may see ATR rise as the market moves from a tight consolidation to a strong trend or we may see ATR fall as the market transitions from choppy price action into a smooth, strong trend. This chart shows a couple of examples where ATR actually falls as price begins to trend, and drops as price enters some choppy consolidation.
Average True Range Not A Direct Reflection Of Price
The ATR has the same drawbacks as the ADX.
- It does not indicate direction, so we often see a rising (or falling) ATR in both an uptrend and a downtrend
- It is a lagging indicator so it will not catch the very beginning or end of a market transition.
- The ATR will not work with range, momentum or Renko bars. Since those are all constant range bars the ATR will essentially be flat and equal to the constant range.
Using Bollinger Bands As A Volatility Measure
Bollinger Bands are calculated based on the distance of price from a moving average over a specified number of bars, typically 20. The bands are a fixed number of standard deviations above and below the moving average, usually two standard deviations.
If the price deviation follows a normal distribution that means that 95% of the normal price fluctuation should be contained within the bands, so a breakout from the bands implies a move outside of that 95% probability range, or an increase in volatility.
Direction and Volatility
Unlike ADX and ATR, Bollinger Bands indicate both volatility and direction. When price volatility is high the bands widen, when it’s low the bands tighten. Since it’s possible to have high volatility during consolidation, typically choppy periods will have wide bands moving sideways, as shown in the highlighted section labelled “A”.
Bollinger Bands Show Volatility and Direction
When prices transition into a trend, the bands will widen and slope up or down, as shown in the area marked “B”. As long as price continues to hug the upper or lower band the trend remains strong, but once price drops away from the bands the market is typically entering a consolidation phase or possibly reversing. You can clearly see these transitions in the chart but I have highlighted small retraces in price to the moving average inside the bands.
A simple trading method using the information the Bollinger Bands is telling us could be:
- Wait for price to poke outside the bands which indicates a large deviation from normal price hence volatility
- Price pulls back to the area around the 20 period moving average (there is no magic here)
- Look for a price pattern to indicate a reversal in price
I put together a post on a trading system that uses the same idea but utilizes Keltner Channels for the volatility and the price pullback measure. I also compare the differences between the two indicators: Simple Keltner Channel Trading Strategy
Bollinger Bands are an excellent volatility and trend indicator but like all indicators, they are not perfect. They also lag price action so they will not catch the very beginning or end of a trend. To be fair, you don’t need to catch the exact turning point but you also don’t want to be taking positions when the move has had a significant run.
They can also signal false transitions as shown in the zone marked “A”, where price bounces between the bands. Although clear in hindsight, at the time price touches the bands it’s not clear if it signals the start of a trend or the beginning of a fading move or reversal.
This is not a single volatility indicator but combines both the Keltner Channel and the Bollinger Bands. It takes full advantage of the difference in the way both indicators measure and react to changes in volatility which can assist you in determining true breakouts as well as the end of a trending move.
This is a special technique and Netpicks has put together a standalone article on this topic so you can better understand and utilize this technique called the Bollinger Band squeeze.
Apply These Indicators To Your Trading
These have been just a few volatility indicators commonly available in all charting platforms. I encourage you to experiment with them and observe them in action. They can be excellent tools to identify market transitions, and combined with other trending indicators or oscillators could form the basis of a flexible trading system.
Keep in mind that nothing is perfect and optimizing indicators such as these used for volatility can have you curve fitting a trading system. This is a dangerous practice and one you should avoid at all costs. You should read: How To Avoid Curve Fitting During Back Testing which will give you concrete steps you can take to ensure the viability of a trading system.
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Market Indicators That Reflect Volatility in the Stock Market
Traders and analysts rely on a variety of different indicators to track volatility and to determine optimal exit or entry points for trades. While high volatility is often a deterrent for a risky trade, increased fear during extreme market moves can also create buying opportunities and provide exceptional trading ground for experienced investors. On the other hand, periods of low volatility—accompanied by investor complacency—can warn of frothy market conditions and potential market tops. Some of the most commonly used tools to gauge relative levels of volatility are CBOE Volatility Index (VIX), the average true range (ATR), and Bollinger Bands®.
CBOE Volatility Index
CBOE Volatility Index is the most widely watched gauge of market volatility. Updated throughout the trading day and known by its ticker symbol, VIX, the index is computed using an option-pricing model and reflects the current implied or expected volatility that is priced into a strip of short-term S&P 500 Index options. Because large institutions account for the bulk of trading in S&P Index options, their volatility perceptions (as measured by VIX) are used by other traders to help get a reading of likely market volatility in the days ahead.
- Volatility can be measured in a number of ways, including VIX, ATR, and Bollinger Bands.
- VIX is a measure derived from options prices and reflects the current implied volatility reflected in a strip of S&P 500 Index options.
- Average true range is charting indicator that shows how wide a stock or commodity’s daily trading ranges have been over time, with high readings reflecting higher volatility.
- Created by John Bollinger, Bollinger Bands® are helpful in seeing periods of quiet and explosive trading.
CBOE Volatility Index stays between 18 and 35 the majority of the time, but it has also dropped into the single digits and has rallied to more than 80. Generally, VIX values higher than 30 indicate increased volatility, while values in the low teens are indicative of low volatility.
Derivatives, such as futures and options, on VIX are actively traded. In addition, leveraged exchange traded funds based on the volatility index—like the Proshares Ultra VIX Short (UVXY) and its partner ProShares Short VIX Short-Term Futures ETF (SVXY)—exist as well.
Average True Range
While VIX measures S&P 500 volatility, average true range indicator, developed by J. Welles Wilder Jr., is a technical chart indicator that can be applied to any stock, exchange-traded fund, forex pair, commodity, or futures contract. ATR calculates what Wilder called “true range” and then creates the ATR as a 14-day exponential moving average (EMA) of the true range. The true range is found by using the highest value generated by one of three equations:
True range = Current day’s high minus the current day’s low
True range = Current day’s high minus the previous day’s close
True range = Previous day’s close minus the current day’s low
The ATR is then created as an EMA (computed using the highest value found when the three equations are solved). A larger ATR indicates higher trading ranges and therefore increased volatility. Low readings from ATR are generally consistent with periods of quiet or uneventful trading.
Bollinger Bands® is another charter indicator and consists of two lines or bands, which are two standard deviations above and below the 20-day moving average, which appears as a line in between the two bands. Widening of the bands shows increased volatility, and narrowing of the bands shows decreased volatility. Like ATR, Bollinger Bands® can be applied to any stock or commodities chart.
The Bottom Line
Market volatility goes through cycles of highs and lows. Analysts watch the direction of market movement when there is a sharp increase in volatility as a possible indication of a future market trend. While VIX is useful in seeing overall levels of volatility of the S&P 500 Index, ATR and Bollinger Bands® can be applied to stocks, commodities, forex, indexes, or futures using any number of charting applications.
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