Like trying to discover the end of the rainbow, capturing the essence of volatility is a challenging and elusive quest. Generally speaking, shorter-term traders thrive upon higher volatility because it allows them to trade market swings more effectively to capture profits whether long or short. Think of it like a surfer whose waves average six feet, but who risks life and limb before the onslaught of an approaching hurricane for the chance to catch the 12- to 15-foot breakers.

Meanwhile, the longer-term investor bemoans higher volatility because, a past market sage once said, Markets slide much faster than they glide. So, while the investor does not mind the rapid upside volatility that carries his portfolio holdings higher, the jaw-dropping downside volatility significantly reduces earlier paper profits. Volatility is a double-edged sword, indeed.

With respect to option trading, volatility is one of the five so-called greeks, a critical Black-Scholes variable in pricing an option. Option traders ultimate success largely depends upon properly forecasting future volatility relative to historical volatility, to say nothing of the duration and direction of a given market. In terms of portfolio management, volatility is normally understood in terms of the standard deviation of returns for a market over a given period of time. In all these varied contexts, the common denominator or basic notion is that both risk and volatility are inextricably linked.

While volatility is loosely defined in terms of price action, it is perceived relative to each participants existing position. If a market is active, it is considered volatile, if inactive it is considered non-volatile. That said, the essential question is, what do we really mean by active or inactive? Stated another way, is there an objective method of quantifying volatility as it relates to price action?

Most traders know which category they fall into, as well as their innate tolerance for risk and volatility. Still, no matter which category you ultimately fall under, a central question or concern both groups grapple with is how a more precise understanding of volatility can help them become more successful in the markets.

BACK TO BASICS

A fundamental concept that helped quantify the elusive nature of volatility was introduced in 1978 by J. Welles Wilder Jr. in his book, New Concepts in Technical Trading Systems. In discussing momentum and volatility, Wilder states the one thing that is directly proportional to volatility is range. Range can be defined as the distance price moves per increment of time. So, integral to understanding volatility is first determining the true range for a market or security.

Wilder defined the true range as the greatest of the following:

1. The distance from todays high to todays low.

2. The distance from yesterdays close to todays high.

3. The distance from yesterdays close to todays low.

In this way, both directional and non-directional movement can be captured and quantified, while gap openings are properly accounted for as well (see Finding the range). Wilder further explained, to be a meaningful measure of volatility, more than one days range must be considered. The answer is to consider an average of the true range over a given number of days (or bars) to obtain an average true range.

The average true range (ATR) is basically a simple moving average of the true ranges over a specified period. Like a moving average calculation, as each new day is added, the last (first) day of a series is dropped to recalculate the adjusted average with the most recent price activity (see A different world).

The duration for ATR can and will vary based upon the time frame. Generally, a value of five to seven is relatively fast and useful for intraday and swing trading while a value of 14 to 30 is more applicable for daily and weekly charting of average true range. Most charting packages use a default of 14 periods to calculate ATR. The value should be adjusted in accordance with time horizon, risk tolerance and trading or investment strategy.

APPLICATION

Using average true range to define volatility has multiple trading applications. This impacts the entire trading plan from development of the basic trading strategy to assessing potential entry levels to ultimately determining optimal stop-loss levels. ATR is useful as a volatility oscillator of price and momentum, whereby both market breakouts and potential trend reversal signals can be more readily identified as well. It also helps define risk. A different world shows how ranges in the E-mini S&P 500 have exploded during the credit crisis. The ATR in the S&P did not surpass 20 for a year preceding the onset of the credit crisis in July 2007; in October it surpassed 70. Traders needed to adjust position sizing as well as stop and exit levels to keep from taking on additional risk in this environment.

Most traders and investors agree that volatility moves in cycles. For shorter-term traders using a breakout system approach, a popular technique using ATR is to add the ATR value or a multiple of the current ATR to the open of the next day and buy when prices move above that level. Short trades are simply the opposite, whereby entries are subtracted from the open using the ATR value.

In a longer-term breakout system, the entry can be based on the close plus the ATR or a multiple of ATR such as 1.5 or 2.0. While not necessarily a stand alone variable, ATR can still be utilized as an important filter.

In terms of stop placement, the ATR from the entry level (or, again, a multiple of ATR) establishes a risk level that is directly proportional to current volatility. In the case of an adjustable trailing stop, the ATR or a 2.0 to 3.0 multiple can be used to trail the previous trading day to capture a good portion of a trending market. In testing this approach, a comparison should be made with ATR relative to the maximum percentage risk-per-trade approach as well as the dollar value in relation to portfolio margin required.

ATR can be used as an excellent stand alone technical oscillator. Some basic tendencies are:

1. High ATR values normally coincide with intermediate and major market bottoms following a panic sell off. In more rare occasions where a high ATR value coincides with market tops, it is almost always a parabolic blow-off top.

2. During an extended sideways move, or a market consolidation phase, low ATR values persist. The more extended the price channel and the lower the relative ATR value remains, the more explosive and extended the price breakout and subsequent future trend will be.

3. In terms of forecasting, the higher the ATR relative to the trend, the higher the probability a significant trend change will occur. The lower the ATR, the weaker the underlying trend movement.

4. Like many other oscillators, ATR divergence signals can occur to indicate imminent price reversals.

Natural gas volatility depicts natural gas displayed with a 14-day ATR. Throughout the dramatic uptrend in natural gas from the $9 price range in mid March, to the $14 top in late June, ATR fluctuated between 35 to 40 with 40 peaks representing short-term bottoms. The ATR indicator formed as ascending triangles with the breakout helping to confirm a major trend change. The sudden breakout and expansion in range visually represented in volatility becomes apparent as natural gas bulls rapidly close out positions. Given the lack of price support, short momentum players and trend-following funds combine to overwhelm the long contract holders.

Confirming the breakout is a daily chart of the S&P 500 index where the oscillator helps identify reversal signals as well as confirm a price breakout to the downside. By examining the seven-bar ATR oscillator, notice how the oscillator spikes coincide closely with prior market bottoms. The price tops coincide with relatively low ATR values, as can be seen in the boxed area. Important to note is the jump in ATR from 20 to 25 at the end of the rectangular box. This dramatic jump in volatility helps confirm the breakout of the channel.

POWER OF VOLATILITY

There are numerous ways to define market volatility. Just like price and volume, volatility cycles occur in all markets. Whether trader or investor and regardless of risk tolerance, time horizon, strategy and tactics, the ATR concept provides a systematic and objective basis not only to more effectively enter and exit new or existing trades, but also to better identify extreme price values when used in conjunction with other technical indicators. Understanding and applying this basic technical concept can yield superior trade selections, as well as a more calibrated risk management strategy to better navigate the uncertainties of price fluctuations.

David Wilder is a market and trading analyst for DeltaSociety.com and writes a monthly advisory covering more than 30 commodity markets. Contact him at trenddw@cox.net.