Volatility
By definition Volatility of price of an asset is the dispersion of its prices with respect to its mean. Most prices can be plotted against time as a time-series and volatility is usually measured as the variance (or square root of variance, which is standard deviation) of that distribution. There can be many measures of volatility in addition to variance and standard deviations, most common one is called 'beta'; which is a comparison of an asset (stock) with a benchmark index (typically S&P 500, which has a beta = 1). There is also VIX or the volatility index. VIX is a measure of 30-day expected volatility of S&P 500 call and put options. Without going into the details of any of this, for a Day Trader, Volatility can also be expressed simply as a daily (or any time frame) range of the price. A more volatile stock or an index will have a higher daily range, a less volatile stock or an index will have a low daily range. Again it is not the definition we are after, it is the usage that is important.
Average True Range (ATR)
J. Welles Wilder Jr. was the person who invented this simple but beautiful technical indicator which measures the volatility of a market in a very practical and decisive way. Wilder started his career as a mechanical engineer, and remained an engineer for just seven years. Then he got interested in the real estate in the 60s. He was from Norris, TN. There he started a real estate business which he then did full time for a few years. His partners bought him out in the early 1970s. At which time he got interested in commodity futures market. Wilder invented many indicators, which are still widely used today, he published most of them in his book New Concepts in Technical Trading Systems (1978). Some of the most famous ones in addition to ATR, are Parabolic SAR, Relative Strength Index (RSI), and the Directional Movement Index (DMI).
An ATR is simply the true Range (TR) of a stock, futures, index... any instrument that can be plotted as a time series. Once is TR is calculated, a moving average is used to smooth it. Wilder used a 14 period MA, which is still being used today, and that is my preferred period as well.
This is the way it is calculated:
The TR is the greatest of the following:
high – low
abs( high – previous close )
abs( low – previous close )
Once the TR is determined, we multiply the previous ATR by the averaging period less one, add it to the current ATR and divide it by the averaging period.
Thus, if using the default period of 14 the ATR would be calculated as follows:
ATR = ( ( Previous ATR x 13 ) + Current TR ) / 14
There are multiple uses of ATR. That will require another post (or may be multiple posts, if I go deep). But here I like to discuss how I personally use ATR on my futures trading activity.
Above is a chart of S&P 500 (well it is actually the chart of /ES, which is S&P500 Futures, but that's minor detail!). Below the candlestick chart with a simple 50 period EMA for clarity is the ATR plotted with the thick light yellow line. Notice what happens during the March Covid lows this year. ATR went up to 180! Meaning, during that time the average daily range of each day was 180. Think about it again: the daily price swing of S&P 500 Index during mid March was 180 points! That is extreme volatility. Why? Because during 'normal' time the daily range of /ES is 20 points. That is 9X more than normal! We came down from that high, but we are still quite high, pulling about 65 right now, about 3X more than normal. There is promise of higher ATR values looming with the general election as well.
Enemy or Friend?
As a day trader, I trade inside each daily candle. At the end of the day, I am usually flat on all trading positions. I rarely hold futures position overnight. Based on my account size, when I trade, I like to make 10-20 points of profit on average/trade. Do you see, if the range is 20, it is basically impossible to make 20 point profit on that day, it is very hard to do 10? Why? Because in order to make 20 point profit on a 20 point range day, I must enter perfectly at high of the day as a short and expect market to fall 20 points after I enter (or vice-versa). That is impossible. This means either I don't trade during that time, or take lower profit margin, like 5-8 points, or maybe hold multi-day position. But if I have a 180 point day, I can pull a 20 point with my eyes closed! Hell, my 9 year old can pull 20 points on those days!! Actually it is easier to teach a 9 year old than a grown man/woman, as a grown person tend to 'think', as opposed to just follow direction :)
That is why volatility is my friend. Bigger range day gives me more opportunity to enter multiple trades, or let me get 30-40 point profits, if the opportunity is there. My life is some much easier during high range days. I normally don't trade every day these days, as I don't need to. I only trade to keep my reflexes sharp. I love trading on panic, those are the easiest days to trade.
Disclaimer: This is NOT professional advice, this is all just my own opinion and experience. I am NOT a Certified Financial Adviser. Consult professionals for any financial, accounting or legal related questions you have.
Charts are created in Tradingview.com, which is a free service.
