One of the most important factors for derivative traders like those who trade contracts for difference to consider before trading a stock or index is its overall level of volatility. In order to do so, you need to be able to quantify volatility and preferably view it graphically.

While there are a number of volatility indicators that can be used, one that was given some prominence at a recent trading seminar promoted by CMC Markets that featured trader Ray Barros was the average true range (ATR).
 
Developed by American technical trading legend J. Welles Wilder and popularised in his book New Concepts in Technical Trading,  ATR is used to gauge an asset’s daily price swings.  Although Wilder developed the indicator to measure the volatility in commodity prices, it can also be used for shares and indices.

As far as a measure is concerned, part of the motive for the indicator was to help account for days when prices gap higher or lower.  A gap occurs when share or index opens the trading session significantly higher or lower than the previous day’s closing price.

It is known as a gap because the result is an empty space on a chart.  Most measures of historical volatility, such as statistical volatility, consider only the closing prices for shares or an index and fail to capture the volatility caused by sharp gaps.  ATR, on the other hand, considers the close, high and low prices of not only a particular trading day but also the previous day.  

The true range – from which an average is calculated – is based on either the  difference between the high and low for a day, the difference between the previous day’s high to the low and the difference between the previous day’s high to the high.

When the previous low is greater than the day’s highs - in the case of a sharp gap down - the range will likely be the difference between the previous day’s close and the high.  Conversely, when there is a sharp gap higher, the range will probably be the difference between the previous day’s close and the low of the day.  

The average true range is simply the average of the True Ranges over a period of days - generally 14 days.  As each day of new data is added, the last is dropped.  

Barros says the ATR is to him an easy way to identify volatility. It is an indicator that can be readily adapted to different time frames. What the ATR allows him to do, says Barros, is easily identify the historic highs and lows as far as volatility is concerned.  

Barros says he has found the average true range to be a reliable indicator of potential market moves. When the range drops it is telling him that volatility is shrinking. A historical low tells him a strong move to the upside is likely often within 48 to 72 hours whereas historical highs will lead to shrinking volatility.

High volatility period occur during sharp swings and violent moves in a share or index whereas low ranges occur during periods of quiet trading.  The ATR indicator, says Barros, can also be combined rather effectively with another more conventional measure of volatility, statistical volatility or standard deviation.  

Calculating the standard deviation of the average true range provides extra insights in helping to determine whether a major move is likely. It can also help to determine target prices and stop loss levels.