Volatility: ATR and Bollinger Bands

A walk through the park on a sunny afternoon and the same walk during a storm: the same distance, but a completely different risk. Markets are similar. Two stocks may each cost a hundred today, but one usually moves two a day and the other eight. If you set the same stop on both, one will throw you out of the position every other day. Volatility tells you what "weather" a given instrument has.

What you will learn

• how to measure volatility with ATR,
• how Bollinger Bands are built and what their squeeze means,
• why volatility is the basis for setting stops and position size.

ATR: the average range of a day

The Average True Range (ATR) is another Wilder indicator. It starts from a single session. The True Range is the largest of three values:

• high minus low of the session (H − L),
• high minus yesterday's close (|H − C₋₁|),
• low minus yesterday's close (|L − C₋₁|).

The last two values catch gaps: when the market opens far above or below the previous day's close, the ordinary range of the day does not show it. ATR(14) is a smoothed average of the last 14 true ranges.

ATR is expressed in price units, so to compare stocks, divide it by the price: ATR as a percentage of price. A stock with an ATR of 2% moves clearly more calmly than one with 6%. That one number tells you how big daily swings are normal for a given instrument.

Bollinger Bands

John Bollinger came up with them in the 1980s. By default the bands consist of three lines:

• middle: the simple average of 20 sessions,
• upper: the average + 2 standard deviations over 20 sessions,
• lower: the average − 2 standard deviations over 20 sessions.

Standard deviation measures the spread of prices around the average. When the market is nervous, the spread grows and the bands widen. When it is calm, the spread shrinks and the bands narrow. For a distribution close to normal about 95% of prices would fall between the bands, but market prices are far from normal, so treat that purely as intuition.

The squeeze

When the bands narrow markedly, we speak of a squeeze. The market is then tightly coiled and volatility is low. Volatility tends to return to its average level, so after a period of calm a move often follows. That is one of the more interesting uses of the bands.

But note: a squeeze does not tell you which way price will go. It only indicates that something is brewing. You have to judge direction with other tools: structure (lesson 1), levels (lesson 2), volume (lesson 4). A breakout from squeezed bands on elevated volume can be a credible start of a move, but false breakouts happen too.

Riding the band

In a strong trend price can "ride" the upper band: closing near it for many sessions in a row. That is not a reversal signal but a sign of strength. A move outside the band does not in itself mean the move will end. The bands describe volatility; they are not limits that price "cannot" cross.

Volatility and stops

Why does this lesson matter? Because ATR answers the question: how far to place the stop? If you set it closer than the typical daily move, the market will throw you out by chance. A popular rule is a multiple of ATR: for example a stop at 2 × ATR from the entry. It is an approximation, not a recipe, but it gives a sensible starting point. We will return to it in detail in the lesson on stop-loss and position size.

Chart example: gold (XAU/USD), daily chart

Gold changes in cycles: there are long periods of calm drift followed by sudden accelerations. That makes good material for observing band squeezes.

Open the daily chart of XAU/USD for the last two years and add Bollinger Bands (20, 2) and ATR(14). Find several moments of a clear band narrowing and check what price did over the next 10–20 sessions. In which direction? Was the move large compared with ATR? Notice that the direction could not be predicted from the bands alone.

How it fails

• No direction. Bands and ATR speak about the size of moves, not their direction.
• Leaving the band does not mean reversal. In a trend it is the norm.
• Volatility changes. The ATR of the last 14 sessions does not guarantee the same range tomorrow, especially around results or important news.
• A squeeze can mislead. The market can stay squeezed for weeks, or break out one way and return immediately.

Check yourself

1. What is the formula for True Range?
2. How are Bollinger Bands set by default?
3. What does a band squeeze mean and does it show the direction of the breakout?
4. What else is ATR used for besides measuring volatility?

Next lesson

Lesson 12. Chart patterns: head and shoulders, flags, triangles (coming soon): you will see how they are born from the fight between buyers and sellers and why many "beautiful" patterns turn out to be traps. Will you believe them right away or check first?

Educational material, not investment advice.