Ever have the right idea on a stock trade, but not give yourself enough room for it work? For example, you buy too many shares, the stock initially drops and forces you to cover, only to see it later rebound and move in the direction you were expecting. You had the right idea, but sized the trade poorly.
Now, this a problem that many traders deal with, even ones who have several years of experience under their belt. Crazy moves happen and we underestimate volatility sometimes. However, some traders are absolutely clueless on volatility and they miss out on good stocks to buy.
One tool that you could use to gauge volatility is Average True Range (ATR). In order to calculate ATR, the true range must first be discovered.
Now, the true range uses the most current period’s high and low range, not to mention, the previous close, if necessary. There are actually three calculations that need to be conducted and then later compared amongst each other.
In other words, the true range is the largest of these following:
The current period high minus the current period’s low. Example: $10 – $8 = $2
The absolute value of the current period’s high subtracted by the previous period’s close. Example: ($10 – $9)= $1
The absolute value of the current period’s low subtracted by the previous period’s close. Example: ($8- $9) = $1
true range=max[(high – low), absolute value(high – previous close), absolute value(low – previous close)
The ATR is a moving average, usually 14 periods, of the true ranges.
How can we use this to make better trading decisions on day trading stocks?
Well, it can help guide us on how to position size smarter. For example, if an ATR for a stock is $2, and we only want to risk $100 on the trade, buying 1000 shares is probably a horrible decision. If the stock moves just 10 cents you’ll be out of the trade based on your risk parameters. However, if the stock has an ATR of $2, a ten cent move is extremely minor.
Of course, there are other elements to consider like support and resistance levels, along with recent highs and lows. But you can see how some traders can size a trade so poorly without considering volatility. Not only that, it could lead to churning their account, hopping in and out of trades and racking up trading fees.
You want to put yourself in a position to win, you’re not doing that if you are not including volatility in your trading decisions on the best stocks to watch.
You could also use ATR as a tool to enter/exit a trade. For example, let’s say the ATR for a stock is $1, and you notice there is no news in the name and it’s down $1.25. If the overall market is relatively normal, then playing for a bounce might make for a decent long. The idea is that on a normal day we can expect the stock to trade in this range and that it should mean revert at some point.
Again, this works best when stacked up with other criteria, but you can still see how it can be useful. On the flip side, if the stock price seems overextended, you might lay off and wait for a better entry given its move and ATR.
A lot of rookie traders get their position sizing wrong, along with entries and exits. Having a greater understanding of volatility and using a tool like ATR can help alleviate some of those easy to avoid trading mistakes and zero in on undervalued stocks.