How Can You Measure Volatility and then how can you use it?

The concept of 'average true range', commonly referred to as
ATR, is a measure of a security's volatility. The true range of
a security for any given day is the greatest of the following
three distances:

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

The average true range is a moving average of the true ranges.
In order to use ATR effectively, you need to ensure that a
sufficient sample is taken. For example, obtaining a two day ATR
or ATR (2) is not sufficient to provide you with a reasonable
indication of that security's normal daily movement. Whereas
using at least 10 days in the average calculation, or an ATR
(10) would provide you an indication of that security's daily
movement over the last 10 trading days (2 weeks). The ATR is
usually expressed as ATR (X) where X is the number of days used
in the calculation of the moving average. The number of periods
you select to obtain the average would depend on your
application.

One application of ATR is that they can be used quite
effectively for setting exits, or stops. Using ATR for exits
allows you to tailor your stop to the security you are trading.
For example, if you used a standard 10% stop, this would be a
tighter stop (i.e. closer) for some securities than for others.
If a security moves 5% a day on average, then a 10% stop would
be tighter than for a security that only moves 1 ½% a day on
average. Using ATR can alleviate this situation.

To use ATR for exits, you would normally use a multiple of the
ATR to ensure a sufficient gap between your exit and the
security's normal price movement. Therefore, using the ATR
without any modification would have your stop too close to the
price and would not allow the security you are trading
sufficient room to move and behave naturally. Depending on your
trading style, you would normally consider using something in
the order of 2 - 3.5 multiplied by the ATR as a suitable
trailing exit. If you used a '2.5 ATR stop', then your trailing
stop will always be 2.5 times the ATR below the highest price
the security has reached since you entered the trade.

Another application of ATR is to loosely categorise securities
as blue chips, mid-capitalisation (mid-caps) or speculative
companies. This concept is called Volatility Percentage. The
calculation that is used is to take the ATR over the last 20
days and divide that by the closing price of the share and then
multiply by 100 to determine a volatility percentage. The result
will be an indication of what percentage the share moves on
average on a daily basis. As a guide, you will discover that
most mid-cap and blue chip companies have a volatility
percentage of under 4% and anything above 5% is normally
speculative. A value of under 1.5% indicates that it may be a
property trust or a security that offers little potential for
short to medium term gains.

About the author: Stuart McPhee is recognized as a leading trading coach and expert when it comes to developing solid and profitable trading plans. Discover what most traders never realise which leads to their downfall. Learn about the importance of having the right trading mindset, sound money management and a solid method - The 3 Ms!
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