There was a time when the after hours trading was so boring that you did not even bother to take a serious look at trading. After all, the chart was basically a straight line with a little bit of movement, maybe a half point of so here and there, and the volume was so pathetic it was simply a waste of time. This is the after hours chart for 11-12-08 and the chart is so volatile you can barely trade it…and the moves occur without warning or any sense of order…of course, the random theorist can now stand up and applaud as this chart gives random movement new meaning.

I thought that I would talk some about the Average True Range indicator at the bottom of page, here is an an excellent technical explanation of True Range:

Developed by J. Welles Wilder and introduced in his book, New Concepts in Technical Trading Systems (1978), the Average True Range (ATR) indicator measures a security’s volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility.

As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind. In 1978, commodities were frequently more volatile than stocks. They were (and still are) often subject to gaps and limit moves. (A limit move occurs when a commodity opens up or down its maximum allowed move and does not trade again until the next session. The resulting bar or candlestick would simply be a small dash.) In order to accurately reflect the volatility associated with commodities, Wilder sought to account for gaps, limit moves, and small high-low ranges in his calculations. A volatility formula based on only the high-low range would fail to capture the actual volatility created by the gap or limit move.

Wilder started with a concept called True Range (TR) which is defined as the greatest of the following:

• The current High less the current Low.
• The absolute value of the current High less the previous Close.
• The absolute value of the current Low less the previous Close.

If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, it is likely that one of the other two methods would be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move). To ensure positive numbers, absolute values were applied to differences.

Of course, I am always interested in the volatility of the market when I begin to look at the feasibility of trading each day. The Average True Range can give me an excellent insight into how to set my stops. I generally like to set my stops at 2 ATR’s or maybe 3 ATR’s on a less volitile day. That being said, the ATR during morning trading on the ES contract was between 3 and 4, sometimes higher. So, if I wanted to effectively trade the market today I would need at least 6+ point stops to stay in a trade and not be stopped out on volatility alone. Many of the traders that email me talk about getting stopped out on trades that are heading in the right direction but one volatile bar stops them out for a loss. Using this ATR method, you can give yourself a good idea of the stop ranges you will need to use to compensate for the unweildy markets of late. Hope it helps