Secret of ATR indicator: To gauge volatility

So, now the important question arises, how to gauge volatility?

There is a well-known adage that in order to make money in the stock markets, there must be price movement. Fortunately, price movement is constant in the markets. However, the degree to which prices move varies. Sometimes, the tone of the market is relatively quiet while on the other side of the spectrum, there are times when prices move at an above-average rate of speed. This speed, at which price moves, helps us to determine the volatility of an asset or an underlying. In simple terms, volatility can be described as ‘the speed at which price movements occur’.  

Volatility is a double-edged sword that traders can’t live without. Volatility works both ways: it’s not all about downside risk. Traders rely on volatility to generate swift profits; it’s an essential ingredient for any swing strategy built on market exposure.  

So, now the important question arises, how to gauge volatility? There are a few indicators that help us to gauge the current volatility in the underlying and in this segment, we will discuss one of them.   

The average true range, also known as ATR, is a volatility-based technical indicator introduced by J Welles Wilder in his 1974 book, titled, ‘New Concepts in Technical Trading System’. The indicator helps an active trader to gauge how much an asset moves on an average over a given period of time.  

ATR: As an indicator to gauge volatility  

ATR indicator does not give buy or sell signals. It is a tool that is used in conjunction with a strategy to help filter trades. It doesn’t necessarily predict anything but helps to determine the volatility of the stock. When the ATR is falling, it is an indication that the volatility of the security is descending; however, when ATR shoots up, it is an indication that volatility is surging. 

In the below chart, we can clearly see that ATR is on the bottom panel while on the top, the price movement of the stock ‘Reliance Industries’ has been depicted. If you check when ATR was moving at a turtle’s pace, it clearly depicted that the stock was in a consolidation or trades in a range-bound manner; however, after February 2017, ATR started to expand, which indicates that the stock is likely to give trending momentum. 

The above article concentrated more on ATR functionality as a volatility indicator; however, there are many other ways to utilise this indicator such as stock selection for trading based on ATR and trailing stop-loss based on ATR.  

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