Volatility is a measure of the amount of change of price. This can vary even for a particular financial security, and also depends on whether there is a strong trend in place or the stock is trading sideways. It really quantifies how much we expect the price to change around while staying the same place, or change around while moving in a trend. The common understanding of volatility isn’t really related to the technical definitions, but the concept is generally understood.
If you would take a moving average of a stock price, and then compare how far the price actually was from the moving average line over a period of days, then you would be quantifying the volatility or variance of the price. When volatility is high then you can think of the trading as being more risky, although if you strike it right it can also be higher gains. With a low volatility, there is less risk and you can see where the price is going before it moves too far. Low volatility and a trending stock price represent probably the safest combination for anyone looking to make money, as you’re not likely to be surprised by unexpected large reversals.
Average True Range
The average true range (ATR) is often used in helping to set a stop loss exit, that is a price level at which you should close your bet. The true range of a share price is the greatest of the following three values: –
- the distance from yesterday’s close to today’s high
- the distance from yesterday’s close to today’s low, or
- the distance from today’s high to today’s low.
The ATR is the average of the true range values over a set period of time, and in the chart below it is 14 days: –
As you can see, and would expect, when the price moves around a lot the ATR is high, and when it is slow and perhaps moving sideways, the ATR goes down. So the ATR gives you an up-to-date assessment of how much the price is changing over time. Your need for it to be unique for it to reflect the latest volatility has to be balanced against the requirement for a sufficient number of days so that the fluctuations are smoothed out.
If the ATR is used to calculate an exit, it is on the basis of the distance the share price would normally travel each day. The preferred method would be to use a multiple of the ATR, and for short-term trends possibly you would use twice the ATR as a stop. What does that mean? It means that you will close out your bet if the share price moves the distance of two average days against you. Note this doesn’t mean that it moves against you just for two days, it could take a week, it just means that the price has moved the distance of two average days.
The advantage of using this method as compared to a percentage or a set distance from the current price is that it always reflects the recent activity of the share price. By choosing twice the normal range you are giving the price room to wiggle around without taking you out of the bet prematurely, but you’re not letting the bet ride for too long when it is going against you. We’ll talk about other types of stop loss later, and as always it is a good idea to experiment and see what works well for the time-frame you want to bet and the financial security you’re looking at. In a later section we look at how you test individual trading plans.
Bollinger Bands Revisited
As we’re talking about volatility, we should just look back at the Bollinger Bands idea. Bollinger Bands are direct measure of volatility, as they are drawn two standard deviations each side of the moving average, and therefore capture 95% of the variation, according to statisticians. So the bands indicate the relative highs and relative lows in relation to the moving average.
Just like the ATR, this can set a target and a boundary. The price will normally stay within the bands with only minor violations, and it’s quite possible to use the band as a target when the price is trending across the width. If the price makes a significant move outside the band, then it signifies a breakout and a change of trend.
What you will most commonly see when the trend is faltering is that the price will stop following the band, in the case of an up-trend the top band, and go back towards the centre moving average. When you have the start of a reversal, like this, some traders take the moving average as a target. If the price passes the moving average then the opposite band becomes the target.
Another way that you can see the trend is about to reverse is by watching the width of the bands. When the bands narrow, traders are not so sure of the continuing trend. They don’t spend money following the trend, but they’re also not sure of a reversal. The narrowing of the bands, called a squeeze, continues until the price cannot be contained any longer and there is a breakout. This breakout can occur in either direction, all that the bands are telling you is that there’s building indecision which will need to be resolved shortly.