The Truth About Volatility

TRADING SYSTEMS

Targeting Price Areas

The Truth About Volatility
by Jim Berg

Many indicators can help identify volatility. But can you use them to target specific price areas for entry signals, trailing stops, and profit-taking opportunities?
Typically, volatility indicators are used to determine the direction, strength, and momentum of a security. The average true range (ATR), one of the more popular volatility indicators, measures volatility by looking at the average price ranges over the past x number of periods, taking gaps into account.
The true range indicator is the greatest of the following for each period:

The distance from today's high to today's low

The distance from yesterday's close to today's high

The distance from yesterday's close to today's low.

Most trading software packages include ATR in their list of indicators, which you can usually overlay on top of a bar chart, as can be seen in Figure 1.

FIGURE 1: POPULAR VOLATILITY INDICATOR. Here you see the average true range (ATR) overlaid on a price chart.

ANALYZE IT
Typically, when analyzing ATR volatility, you would focus on volatility at tops and bottoms and during price consolidation and retracements. However, if you incorporate the ATR into a few simple formulas, you may be able to identify where to enter and exit trades, and make a reasonable profit. Before going any further, I think it's fair to say that I apply my ATR volatility analysis only to securities that are in a rising trend. After all, it is the path of least resistance. Who wouldn't want to buy securities when they are rising and sell them when they are no longer in a rising trend?
When is a security in a rising trend?

When it is making higher highs and higher lows on a weekly chart

When closing prices are above the 34-week moving average

When the 34-week moving average is rising.

The price movements in the weekly chart of The Boeing Co. (BA) in Figure 2 certainly meet these criteria. If you look at the chart, you'll see that higher highs formed at (A), (B), (C), (D), and (E). Higher lows formed at (F), (G), (H), (I), (J), and (K). Prices closed above the moving average, which started rising in June 2003. The point at which the moving average started rising would have been a good entry point for any long trade, but it's possible to miss that trade. If you did miss the opportunity to enter a trade at this point, where will you find subsequent entry signals?

FIGURE 2: A SECURITY IN A RISING TREND. Price movement meets the criteria for a rising trend.

...Continued in the February issue of Technical Analysis of STOCKS & COMMODITIES

Excerpted from an article originally published in the February 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.

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