prevailing price bar is an outside day, gap,
or inside day. For example, if the prevailing
high is higher than the previous day’s high,
and the prevailing low is lower than the
previous day’s low, then you’d use the difference between the current high and low.
If there’s a gap up or down, or if the prevailing close is within the high-low range of
the previous day, then you’d use the abso-lute-value calculations. When using those
absolute values, you can expect ATR to be
lower for lower-priced stocks, and higher
for higher-priced ones.
To calculate ATR, take the average of
the price ranges. Typically, price ranges
are averaged over 14-day periods. In other words, you go back 14 days, add up the
true ranges, and divide by 14. Generally,
when price moves strongly—such as before
earnings—you might see large price ranges.
When prices move within a trading range,
meaning that movement is relatively flat,
price ranges tend to be small.
You can use ATR to identify market
changes. For example, if price has been
trading within a range for a relatively
long time, and then starts to show signs
of breaking out, you may see ATR start to
rise. On the other hand, if a volatile market
strong wind forecast is
enough to send most of
us indoors. Not surfers,
though. For them, it’s a
different story—a surfer
lives for windy condi-
tions. But it has to be the right kind of wind.
There are plenty of factors that impact the
quality of the surf—tide, type of wind, type of
break, direction of wave. The right combination creates the perfect surf. Surfers long for
those days—that’s when you’ll find them at
the beach in swarms.
The relationship between surfers and
surf quality can be compared to the relationship between option traders and volatility (“vol”). In a high-vol environment,
options trading activity typically increases.
It’s an option trader’s playing field.
All option traders know the ubiquitous
Cboe Volatility Index (VIX). And that a
high VIX generally indicates high vol. But
VIX isn’t the only volatility indicator out
there. Stock traders who rely on charts may
also consider vol, but they approach it a
little differently. Stock traders have more
choices when it comes to vol indicators. So,
can option traders use some of those studies to help analyze a stock’s options?
VOL, WHERE ARE YOU?
When vol starts heating up, it’s time to look
for opportunities. If two or more indicators
confirm high vol, the likelihood of seeing
increased trading activity is higher, too. We’ll
look at three popular vol indicators stock
traders use that option traders could adopt
into their trading decision-making rules.
Average True Range. J. Welles Wilder developed the Average True Range (ATR) indicator to measure volatility in commodities,
although it’s widely used by stock traders as
well. ATR looks at the difference between
the current high and low, the absolute value
of the current high minus the previous
close, and the absolute value of the current
low minus the previous close. The method
you might choose depends on whether the
FIGURE 1: Price range, gaps, and volatility. The Average True Range (ATR) indicator picks up the pace when prices
break out of a consolidation with a gap upward. ATR moved lower even though prices continued to trend up, suggesting price ranges were smaller, and vol was drying up. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
starts to trend up or down, ATR could fall.
You can see this in Figure 1. After a consolidation period where the average price
range was low, price gapped up. Notice
how ATR spiked and continued moving up.
After trading activity slowed, even though
the market continued to trend up, ATR
Bollinger Bands. Developed by John
Bollinger, Bollinger Bands are popular
and available in just about any charting
software. They’re used to identify if prices
might be high or low on a relative basis over
a specific time frame. As the name suggests,
they’re bands or envelopes that can be
overlaid on price charts.
Bollinger Bands are calculated based on
the distance of price from a moving average
over a specified number of bars, typically 20.
The bands are a fixed number of standard
deviations above and below the moving
average, usually two. Because the bands are
based on standard deviations, they adapt to
changing market conditions. Two standard
deviations means that 95% of price movement will be within the bands. So, when
price breaks out above or below the bands,
think of it as out of the ordinary, which can
Prices continue moving up
but ATR moves lower