The In-Depth Guide To Understand the Average True Range and Historical Volatility. Read and learn how liquidity and market news affect volatility.
The Average True Range indicator is the most widely used technical analysis tool to calculate financial markets’ historical volatility.
This article explores historical volatility and why it is so important to take it into account when trading.
Keeping volatility under control will make a massive difference in your trading results, allow you to make more informed decisions, and moderate risk.
Historical volatility is the measure of the percentage change in the price of a financial instrument over time; in technical analysis, there are various ways to measure historical volatility, but the Average True Range is the most known.
If you are a discretionary trader, you must always know how the market is moving and how much volatility is present at any given time.
Most strategies only work with specific volatility; it is almost impossible for a trading strategy to achieve the same results in periods of low and high volatility.
The need for an automatic trading system to adapt to volatility is essential for the setting of stop losses and, therefore, position sizing. Only in this way is it possible to maintain similar exposures during different periods of market volatility using the Average True Range indicator.
Only automatic trading systems and strategies that use the Average True Range, adapting to volatility, will overcome some unexpected and sudden changes in the market’s speed.
More in-depth about Historical Volatility Calculation? Here you can find a free course.
What does historical volatility show us with ATR?
The historical volatility calculated from the Average True Range shows us how much the financial instrument has moved in the last period.
The default period is 14, so it examines the volatility of the last 14 candles.
The Average True Range calculates the range, taking into account the gaps between one candle and another, and this aspect is much more important in daily or weekly timeframes.
The ATR then draws a line representing the average values of the ranges, including the gaps, and is, therefore, unable to predict anything about that financial instrument’s future volatility.
The Average True Range shows us two types of data, the static data of the current volatility and the dynamic data relating to the increase or decrease in volatility.
The static volatility data is useful for calculating our position size or our stop loss, while the dynamic data serves us to understand if volatility is increasing or decreasing.
By modifying the ATR period, we obtain different information; if we lengthen the Average True Range period, we get a much more smoothed curve because the single data influences the time series less.
If we decrease the period too much, the Average True Range line becomes very noisy and less useful; in this example, you can see two ATRs, the first at 5 periods while the second set at 50.
Volatility is cyclical
We must always remember that volatility is more easily predictable than the price because it is cyclical, and low volatility moments always alternate with moments of high volatility.
Try to think of price congestion daily; in these cases, the volatility drops considerably. The congestion can last a long time, but there will be an increase in volatility when the price breaks the channel.
If it is a stock market, and the breakdown will happen to the downside, there may be a more significant increase in volatility, but it would still increase in any case.
Now think of a sudden fall in the prices of a share following bad news, volatility will go up a lot, but then the stock will reach a minimum price from which to recover, and volatility will go down.
Therefore, it is inevitable that volatility is cyclical; the problem is that it is difficult to predict when the change in speed will take place both using technical analysis and using fundamental analysis.
There are also some investment strategies that select stocks based on their historical volatility.
Average True Range, volatility and news
We must not believe that incoming news always generates volatility; the news is often discounted by the market days or weeks before.
On wall street, it is said to sell the news for this very reason, because when the news is out now, the trade is in the public domain and will no longer be profitable.
We are not talking about sudden news like the 2011 earthquake in Japan, but about news related to macroeconomic data already planned and analyzed.
Every day an infinity of news comes out that can move the financial markets, most of this news is presented at set times, and many analysts make predictions about it.
If the analysts’ forecasts are correct, there shouldn’t be much volatility following the news, precisely because the market has already moved in that direction driven by the analysis.
However, when the data surprises the analysts, moments of panic are created. The market needs to reorganize and find the right price after the surprise. In these moments, the volatility could increase.
Our advice is: never use the news to predict volatility changes because it may not have a statistical value in your favor.
Volatility is like speed and Average True Range is the speedometer
And it precisely speeds that it is; imagine the financial markets as a car, the trend is the direction in which the vehicle is moving, and the volatility indicates its speed.
Like the speed of a car, volatility can change quickly, much faster than direction, and it also happens much more often.
When the speed increases, the trend generally tends to consolidate both bullish and bearish moments, but huge differences are based on the trend’s direction.
Keep in mind: when the markets are rising, historical volatility is generally low. When they go down, it tends to increase and sometimes in a significant way. This rule is especially true for the stock market.
When the stock market goes down, it generally violently follows some news so that the speed can increase wildly.
A stock can take months to rise by 10% and a few days to lose all the gain.
When the speed increases and the volatility is high, the only thing to do is decrease your exposure in the market; thus, you will avoid significant drawdowns and avoid being continually hit by stop losses.
Average True Range, volatility and liquidity
The first thing you need to understand is why the financial markets’ volatility rises and falls and the price dynamics behind these changes.
In our experience, the more liquid the financial markets are, the less volatile they are. Can you imagine why?
We try to explain the concept to you as clearly as possible. A financial market must have buyers and sellers.
If you have never seen it, this is a book where you can view all the orders entered at the operators’ different prices.
When there are enough buyers and sellers at every price, the market moves calmly, it may have direction, but it moves slowly. There are exchanges and investors with a very different view of what can happen at every price, so many buy and many sell; volatility is low.
But suppose that news or another sentiment suddenly becomes bearish, and many buyers turn into sellers.
From a condition where there were many buyers and sellers at each price, we will pass to a situation where there will be many sellers and few buyers.
In these cases, gaps are created in the book because those who want to sell must lower the price more and more to find buyers, and this absence of buyers causes the price to collapse quickly.
The more institutional operators are present in the financial market in which we operate, the less likely there will be an absence of buyers and sellers; for this reason, it is impossible to see high volatility in an index such as the S&P500.
In a very liquid market, there are market makers, hedge funds, banks, and big traders who, with various strategies in place, will flood the order book at any time without creating gaps.
Have you ever noticed how there is often a substantial increase in volatility during the Christmas holidays or during August? The absence of operators due to holidays decreases liquidity and therefore increases volatility.
The limits of historical volatility
The Average True Range and historical volatility are essential but not infallible; like any technical analysis indicator, you have to take what good it has to offer and know its limits.
The most significant limitation of historical volatility is that it is the past. It gives us no information on the future, and unfortunately, assuming that volatility remains unchanged is often a mistake.
Think carefully about this: what happens when there is a period of very low volatility? A range is created, which is then broken with force, and high volatility is generated.
On the contrary, when there are periods of high volatility, the price stops distributing or accumulating. The essential point is that volatility is variable over time.
We take the value of the Average True Range of the last 14 periods. We have a value that could be distorted 5 minutes later by news that could cause volatility ten times higher than the current Average True Range.
Setting a trade and its position size through data from the past tends to fluctuate may not be the best choice.
Let’s assume we open a trade by calculating a stoploss based on the Average True Range. Therefore, the last 20 days’ volatility was very low; we will probably use a higher position size than the standard.
But if suddenly volatility were to change, we would find ourselves in an expensive position compared to the current volatility, and we would easily hit our stop loss.
To overcome these dangers, we consider these hypotheses using a higher Average True Range multiplier for more excellent protection.
We like to use an Average True Range multiplier of 3 to have enough room for maneuver to absorb sudden volatility changes.
There are other indicators to analyze and anticipate future volatility and look at implied volatility, as we will see better in the next paragraph.
In any case, historical volatility, albeit with the limits above, is essential to build a stable and efficient trading system.