Stock market volatility, the moves of a stock up and down over a day, week or other period, causes investors to fear making a decision. When the price of their stock moves against them they become afraid to sell. Yet, stock market volatility can work for investors, if they use an indicator named Average True Range (ATR).
Average True Range, the Volatility Indicator
Most investors use the average true range or ATR indicator to help them establish a trailing stop that is based on the volatility of a stock. As mentioned earlier, the period you select influences the size of the calculated average true range. If you are a longer term investor, then a weekly or even a monthly average true range might be appropriate for you. These investors are willing to absorb more volatility in the stock before the stop is activated.
If you are an investor who does not wish to experience so much volatility in your stock or has a shorter term perspective, say three to six months, then the daily average true range calculation might be more appropriate.
In addition, investors will multiply the average true range indicator by some multiple, such as two, to lower the potential of a premature sale of the stock. As with many indicators, investors should review the history of the stock market volatility indicator to get an idea of how it works in a similar situation to theirs.
For Trading Online Markets, we use the ATR indicator to help determine the trailing stop based on the stock’s volatility. Typically, we use the daily period and a “2” multiplier to establish the trailing volatility stop. This trailing stop is compared to support based trailing stops to select the best trailing stop for the specific situation. Each stock on the Premium Members Watch List shows the average true range indicator and identifies the best trailing stop for that stock.
For example, Apple (AAPL) might offer you a good investing opportunity. However, you wish to protect your investment from an unwanted loss, yet you do not want to be “stopped out” due to the normal volatility of the stock. The average true range indicator might be of use in this situation.
Below is a chart of AAPL that includes the ATR indicator at the bottom of the chart. As an astute investor who is a premium member of Trading Online markets, you bought AAPL on January 22, 2009 at 88.00. On that day the average true range indicator was at 4.2. If you had used this number as you trailing stop you would have been stopped out on January 30, 2009 at 90.80 for a gain of 2.2 points. Not bad for just a couple of days. On the other hand, if you had multiplied the ATR of 4.2 by 2 your trailing stop points would be 8.4, giving you more room for the price to move. In this case, you would have been stopped out at 94.6 on February 17, 2009 for a gain of 6.6 points. Another nice gain.
This is an example of how you might use the average true range indicator to provide a volatility based trailing stop. The decision to use a multiplier with the ATR depends on the risk you wish to take with your trade vs. the potential reward.
Background of Average True Range Indicator
J. Welles Wilder, a commodities trader, introduced the Average True Range (ATR) indicator in 1978. Presented in his book, New Concepts in Technical Trading Systems, Wilder offers a method to calculate the volatility of a stock measuring the degree of price movement. The average true range indicator is very useful to determine the trailing stop of a security.
As a commodities trader, Wilder had to deal with limit and gap moves that cause higher degree of volatility. These moves cannot be properly addressed with a formula that only measures the high and low range of the volatility of a stock.
The calculation of the volatility of a stock starts with a concept called True Range, which takes the greatest of the following:
- The current high less the current low;
- the absolute value of the current high less the previous close; or
- The absolute value of the current low less the previous close.
The measure only uses positive numbers, so absolute values are applied to differences.
The Average True Range indicator is a moving average of the true range for a set number of periods. Most investors use 14 periods to calculate the ATR value. Other periods can be used, if so desired. In addition, the average true range indicator can be calculated for any intraday period, as well as daily, weekly and monthly periods to determine the volatility of a stock over that time frame.
The ATR will vary in absolute size by the price level of a security. The higher the price level, the higher the average true range is likely to be. In addition, the average true range will be higher for longer periods. The weekly average true range will be higher than the daily.
Calculating the average true range indicator is slightly complex, though it is possible with a spreadsheet. Fortunately, several stock charting services provide the average true range indicator as a part of their service, including Stockcharts.com.