Average True Range & VolatilityRisk Management
The average true range (also called ATR) is a measure of the volatility of an investment. But before we discuss ATR we must talk quite frankly about volatility, which is essentially how drastically an asset’s price can change over a period of time. Volatility is often believed to be the risk of an asset, with higher volatility environments being riskier. This is and is not true.
Volatility and Opportunity
First, imagine if an asset has no volatility, dividends are zero, and commissions still apply. You purchase it at $20. The price doesn’t move. 10 years later the asset is still $20. How much money did you make? Zero. In fact, after commission fees, you took a loss. There’s no volatility at all, so you can’t earn a return but you also can’t take a loss (other than commissions on the investment). You need volatility to earn a return.
Volatility is really an opportunity, for both risks AND losses. But volatility really splits into two camps: volatility to the upside which brings you a favorable return if you own an investment, and losses if short selling. Volatility to the downside brings you losses if you own the investment but gives returns if short selling. If you own an asset and I quadruple the volatility to the upside but set volatility to the downside at zero, are you worried about taking a loss? No. Downside volatility is the risk of loss when you own an asset, and I’ve removed all of it.
Volatility as a Problem
Volatility isn’t bad unless you’re on the wrong side of an asset’s price movement. The main issue with volatility is that it’s not easily predictable and can quickly reverse, leaving you in a situation where you’re suddenly taking losses. This is why when volatility rises you should reduce exposure or re-balance your portfolios in a manner that reduces your risk of suffering losses. Its volatility’s reversal that could destroy you if you’re still there, sitting on the wrong side of the trade.
Average True Range
Now we can discuss Average True Range. the average true range is a simple volatility measure which was created for commodities but is applicable to anything quoted in OHLC format (Open Price, High Price, Low Price, and Close Price). It simply takes the true ranges for a time period and averages them. The true range for each time period is the highest of the following: Current High minus Current Low, Absolute Value of Current High minus Previous Close, or Absolute Value of Current Low minus Previous Close.
If you have an asset’s 30-day average true range, you’ve calculated the true range for the last 30 days of the asset and averaged them together. Computers and brokerage trading platforms usually can do this for you on the spot. Reading average true range very simple: assets with high volatility levels have high average true ranges, and assets with low volatility levels have low average true ranges. True ranges change over time, increasing or decreasing for different periods of time and different measurements of length. You can test multiple periods or a single period if desired.
The average true range is fairly valuable information, and lets you know what to expect from an asset. You should consider your comfort level before having a portfolio full of assets with high average true ranges compared to relative alternatives. You should also consider the average true range of your portfolio, along with standard deviation, Sharpe, and Sortino ratios.
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