When trading stocks, the smart speculator pays close attention to volatility. When a stock or futures contract moves through a greater range of prices during a trading session, the opportunities for profit -- and loss -- are greater. To measure this important investment metric, J. Welles Wilder developed the Average True Range or ATR.
1. Open a chart of the stock, currency pair, futures contract or other investment of interest. Following instructions for your charting software, apply the average true range indicator to the chart. This can usually be done with a pull-down menu or by right-clicking on the chart itself and bringing up a menu of technical indicator selections.
2. Set the period over which the software calculates the ATR. This can be hourly, daily, weekly, monthly or some other time interval supported by your charting software. The shorter your trading timeframe, the shorter the ATR period should be. Long-range volatility values are most useful for buy-and-hold investors.
3. Set the number of periods you want to calculate the ATR. A typical value is 14. The calculation of the ATR is based on the difference between the high and low closes for all of these periods, added together and divided by the number of periods. The higher the resulting number, the greater the volatility.
4. Follow the ATR indicator, which appears as a solid line at the bottom of the chart on a separate graph. The ATR moves up and down like a price indicator; ATR values relate to a stock's price, so that the lower the price of the stock (all else being equal), the lower the absolute value of the ATR. These values run on the vertical axis, while the time intervals appear on the horizontal axis.
5. Consider a trade when volatility increases, as shown by a rising ATR indicator. The absolute value of the ATR is not relevant to volatility (since it depends on the price of the investment), but the direction of the line is. When stocks, commodities or currencies become more volatile, their prices are changing more quickly and the chance for profit in a short-term trade increases.
- The ATR is especially useful when trading currencies or futures subject to daily limit moves.
- Always place stop-loss orders when trading short-term. The stop prevents you from incurring a big loss if the trade goes against you. Allow profitable trades to remain open and raise the stop as the price continues to move in your favor. This locks in your profit.
Items you will need
- Trading account
- Charting software with ATR indicator
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