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Resident trader
How to profit from volatility
Will Kraa, October 15, 2007
A word that is commonly used in connection with the financial markets is ‘volatility’. As used here in its figurative sense it denotes the subject is moved about by chance events. There is no doubt that markets such as the sharemarket are influenced by events that are often quite unpredictable. There are news events, large institutions buying and selling, happenings in overseas markets, the weather, the emotions of traders and a lot of other things which can affect share prices.
These daily unpredictable movements in the price are what is described as volatility. For any particular instrument there are times when daily price movements can cover quite a wide range and other times when they do not move much at all. In other words there are times when volatility is high and other times when it is low.
Times of high volatility can make trading difficult for most traders but there are some who can profit from it. Prices may trade in a very small range or they may fluctuate wildly. Some shares trade in a very narrow range and others regularly have large gaps in the chart. Sometimes, as in the recent market ‘correction’, the prices of almost all stocks in the market exhibited high volatility and trading became very unpredictable.
In spite of these fluctuations in price there are discernible trends when prices move consistently in one direction or another. For instance at the beginning of this year it was possible to buy BHP shares for about $24, but at the moment you would have to pay about $45. During the time in-between the price has fluctuated on a daily and weekly basis but overall has consistently moved in an uptrend. In hindsight it would have been quite clever to put all your money into BHP shares, trading at $24, at the beginning of the year. In fact it might have been even smarter to have borrowed all the money you could lay your hands on to buy BHP shares.
But if you had done that then what would you have done during July and August when prices appeared to be fast heading back to your buying price? As you watched your profits diminish rapidly, and possibly suffered margin calls, you might have sold (as many people did); and unless you bought them back somewhere near the end of August, you would now be very disappointed.
It would therefore be desirable to somehow distinguish between price moves that indicate the trend might be over, and those to be ignored as simply the daily or weekly volatility that the market routinely exhibits. And it would be just as handy to have some way of figuring out that the trend has resumed after it has given the appearance of being over, so you can get back in to profit from the rest of the trend. An indicator based on volatility might be useful here.
There are ways of measuring the volatility of the share price and this can be done by seeing how far the price moves each day and plotting the results as an indicator. We should also take into account any gaps in the chart as the price might open on some days much higher or lower than the close of the previous day. So what we can do is measure the range of the day and add the size of any gap that occurred. If you have a look at the chart you can see a gap at the red arrow. The closing price of the lower candle is $15.30 and the next day there is a gap of 4 cents as it opens at $15.34. It closes at $15.50, so the Range for the second day is 16 cents ($15.50 - $15.34) but to get the True Range we need to add the 4 cent gap from the day before to give a True Range of 20 cents.
This indicator - made up of the daily true range of price movement - we could call the True Range indicator and it is shown just below the price chart. As you can see it is a very jagged line, which probably is not very useful to us as it simply displays the volatility each day. However, by creating a moving average of these daily values we can smooth it out to get the line seen in the bottom pane below the chart. This one is averaged over a period of 10 days and so is called the 10 day Average True Range or ATR(10). This line shows how the volatility gradually changes over a two-week trading period (5 trading days per week).
It should be noted that this line does not necessarily follow the direction of the price - it is simply an indication of how volatile prices are. Now this is all very well but how can we use this indicator? Actually, the indicator itself is not used a great deal, but the information it displays can be used. However, not by plotting a line as we see here.
The Average True Range tells us something about the size of random price movements we might expect at any particular time on the chart. At the vertical line on the chart we can see that the Average True Range, or ATR(10), value on that day is 0.28 (bottom pane) but on the day itself the range is $0.43 (High – Low). To this we need to add the gap of 4 cents so the true range is $0.47, as shown in the middle pane (ATR(1) = 0.47). This is quite a bit more than the average of the last 10 days. So this is a day of high volatility compared to the average for the last couple of weeks.
In an uptrend such as shown on the chart (starting near the red arrow) it would be very profitable if we could buy somewhere near the start of the trend and sell near the top. The question is: how to do we know when the uptrend is likely to end so so as to know when to sell? This is where the volatility measure can help.
It would be reasonable to conclude that when the price changes much more than the usual daily range of price movement, this could be the sign that the trend is about to change. But we have to make sure we are not tricked by a very volatile day like this one at the vertical line. If the price deviates by say twice - or even three or more times the average true range from where it normally trades - then this could be a good warning of a trend change.
What we can do in an uptrend is to subtract a multiple of the value of the ATR from the closing price (or the high or low) for each day. As prices rise, we can plot a line below the price and - say that if the price moves below that line - it might be an indication that the trend has changed. The values for the multiplier are usually in the range of 2 to 3.5.
On the chart I have marked a vertical line at a time where there is a high in the uptrend and the prices shown at the top of the chart are the prices for that day. So the closing price for that day is $17.65 and also it shows that the ATR(10)= 0.28.
(The wrong chart was used on Sunday 14/10, but was replaced with the correct chart as of 6am 15/10)
If we use 2 as the multiplier, for instance, then on that day with a closing price of $17.65 and the ATR(10) of 28 cents, we get 2 x 28 = 56 cents, and when we subtract that from the closing price we get $17.65 - $0.56 = $17.09. I have marked that on the chart with a red line. Now, you can see three days later the price actually closes below that price. (Of course, on that day when the price has gone down - if we did our calculation again we would come up with a lower place for the line but it would be no use to lower it to the new value. If we did that we would never get below the line since it would simply follow prices down.)
So we need to have our exit line follow the prices up (in an uptrend) but not down. Therefore on a day that the price is down we do not recalculate the value but leave it where it is. Then when the price begins to fall it will eventually close below the line and we can use it as a signal to close the trade.
In this case the price closes below the line on the third day after the vertical line when our calculation was done. The next day the opening price is $17.04 which is still below the line and we exit the trade at this price. Naturally it would be disconcerting at the end of the day to see that the price has gone up for the day to close at $17.24, which is no longer below the line.
It would appear that the trend is not over as prices rise again which may be somewhat disconcerting. Maybe we should have used a larger multiplier and then this would not have happened so we might try that. Say we use a multiplier of 3 and then our figures are $17.65 – (3 x $0.28) = $16.81 (first blue line) and we would obviously not be exiting the trade at this stage.
Now notice that prices go higher and the highest close is on 27/01/05 at $17.85 with an ATR(10) = 0.28 again. That means the line should now be moved 20 cents higher to $17.01 (second blue horizontal line) and seeing the price now begins to trend down the line is left where it is. Then the price closes below the line and gives an exit signal. The exit now is on the next day (24/02/05) at the opening price of $17.00 and again the day after prices close higher for the day to stage a brief rally but soon they trend down again.
This time it turns out that the trend is over and in reality was over at the first exit. The share traded sideways with much volatility during the months following the first exit but did not make much progress and then went into a downtrend. Even today it is trading at a lower price.
It turns out that this exit on a later date using the higher multiplier is actually not a better result at all! We have tied up our money and been exposed to market risk for nearly another three months and finished up selling at a lower price. Maybe changing the multiplier to a larger number was not such a good idea! There will always be debate about the value of the multiplier to use in the range from 2 to 3.5.
The greater the value of the multiplier the less likely it is that you will exit a trade before the trend is finished but also the more of your profit you will give back before closing a trade. So it will be the short-term trader who would use a multiplier of 2 and the longer-term trader who would use a multiplier more like 3 to 3.5. It is also possible to use the indicator on a weekly chart and that will have a somewhat similar effect to having a larger multiplier.
There are other things that can be done to fine tune the use of this indicator, which will be discussed next week. Of course, these days, it is just not done to have to manually calculate all this when we have computers to do it. Next article I will demonstrate how to set up AmiBroker to calculate and show the line as an indicator that can be used to protect profits and to tell when to exit trades.
There is no perfect indicator but it is possible to construct a good and profitable trading system by using the volatility indicator. You do not need expensive software to give you the advantage of the best indicators to use in trading. Very expensive software is available with proprietary indicators but remember any indicator is simply a calculation based on the same data of price and volume and cannot give more information than is in that data.
Summary
Average True Range is a measure of volatility of share price movement. It is a moving average of the daily (or weekly) range of price movement including gaps. When multiplied by a factor of 2 to 3.5 and plotted below the price in an uptrend it gives an indication of when prices have moved well away from the usual range. This may indicate that there is a change in direction and signal the end of the uptrend.
Click here for "How to profit from volatility - part 2".
More articles from this week's CompareShares newsletter:
Companies: Exclusive interview with the Pratt dynasty
Stocks: Stock picks for the long haul: Reece Australia and ARB Corporation
Politics: Who are the better economic managers?
Commodities: Wheat prices soar
Technical analysis: Elliott Wave theory spells doom and gloom for the US market
Stock of the week: Imdex Limited
Resident trader: How to profit from volatility
Smart investing: Counting the cost when confidence is lost
Economics: Australian employment data signals rate hike
Stocks: Construction: a two-speed industry
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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