Wednesday, May 12, 2010

ATR again

It’s been some time since we looked at ATR chart. In the mean time some things changed, so it is a time to take new look at the ATR chart.

On the top of the chart is ATR% (5 day), so instead of looking into points values for ATR we divided ATR with price in order to get percentage changes. Chart is from early 2006 as I wish to compare different periods of Top40 behavior.

During last few weeks ATR bounced from very low levels and has reached top of our range (around 3%). Upsurge was quick; it happened over just few days and caught many traders in sleepy mode that was persistent over last year.

So, what does increased volatility mean?

For intraday traders it is very welcomed, because there are more points in daily range to be taken.

For swing traders it is welcomed as well, for the more or less same reason – there are more points in swings and systems should produce more points.

For long term investors, on the other hand, it is not welcomed at all. Volatility tends to increase as stock prices decline and decreases as the stock prices rise. The reason for this to occur is because falling stock prices mean greater uncertainty with regards to future risk. This leads to an institutional demand for insurance against future losses, meaning a higher demand for put options/short selling. On the other hand, increasing stock prices mean less uncertainty and subsequently less demand for put options, resulting in lower volatility.

The investor or trader can always count on volatility eventually returning to normal levels after going to an extreme. This principle is called “the mean reversion tendency of volatility”. It may take anywhere from days to months, but sooner or later volatility always comes back to middle ground.

Advise for traders is to use this opportunity to trade well (and manage risk extremely well) and make as many points as they can, because sooner or later we will be back to the middle of the range as per our chart, where our systems will not produce as massive number of points.

In my book – volatility brings opportunity.

Trade with trend!


Anonymous said...

Excellent post.

Alsi Trader said...

Thank you Anonymous. Will try to keep them coming.