There are instances that traders pay attention to the degree of price volatility in times of market uncertainties. In most cases, some investment opportunities are greatly exposed to either high price volatility or low price volatility. High volatility can bring a higher risk to the investment; nonetheless, a higher return on investments is also expected. It is important that you learn about the sense of price volatility prior to investing in the stock market.
The quick change of prices is associated with supply and demand and there’s an indicator which can provide price volatility. A technical analysis volatility indicator called Average true range can do the job for you.
In 1978, J.Welles Wilder developed Average True Range (ATR) to gauge how a volatile a stock is in a specific period of time. Technically, the small range means that there’s low volatility and the wider range means high volatility for stocks. Most of the popular indicators determine the price direction, but ATR focused on volatility caused by price gaps and limit moves. Through this, the traders may manage their position in accordance to volatility
To calculate the average true range, you need to identify the true range first. The range is defined by Mr. Wilder as the distance the price moves per increment of time on his book New Concepts in Technical Trading Systems. The true range can be calculated in three simple equations; current period’s high minus the current period’s low (H-L), the absolute value of the most recent period’s high minus the previous close (H-C.1) and the absolute value of the previous close minus most recent period’s low (C.1 –L).
The first equation is commonly used by neophytes and when the market demonstrates only a bit of instability. When the market has gapped wider, the second equation is recommended while when the market opens with a gap down, the third equation is suggested.
For instance, Alphabet had a session high of 848.83 and a session low of 841.44 on day 1. Using the first formula, the true average would be 7.39.
To better understand the concept, Mr. Wilder recommended using 14-day time frame for the average true range. Traders can choose the time frame they prefer, but, in general, the longer timeframes could lead to fewer trading signals and shorter timeframes may increase trading activity.
ATR can be used as a considerable factor in position sizing in financial trading as it provides an adjustable risk limit which depends on the market volatility for strategies without an absolute stop-loss settlement. The value serves as the size of the probable adverse movement in identifying the trade volume in light of the risk tolerance of the trader. Typically, a more volatile market has a shorter trading position compared with a less volatile market in the trader’s portfolio.
Traders know that market volatility usually follows a certain pattern. More often than not, the movement repeats due to similar reasons. These are some of the principles to be remembered in using this indicator.
1. 1. ATR can be added to the closing price and the trader can buy whenever the next day's price trades above that value.
2. 2. Whenever price the closes more than an ATR above the most recent close, a change in volatility has occurred. In this scenario, taking a long position is recommended since the stock may follow through in the upward direction.
3. 3. Whenever the price closes more than one ATR below the most recent close, it means that there is a significant change in the nature of the market. Traders may close a long position as the stock will likely enter a trading range or reverse direction.
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