When it comes to technical analysis, many people don’t know where to start.
That’s why last weekend we introduced you to one of the more basic tools, moving averages.
However, that’s just the beginning. There are many types of technical analysis indicators. Today we’ll show you another.
While we said that moving averages play a big part in Slipstream Trader, Murray Dawes’ analysis, there’s another indicator that plays an even bigger role. It’s the average true range indicator. It’s more commonly known as the ATR indicator.
Now unlike moving averages, which help you determine the market direction, the ATR indicator gauges market volatility.
Initially created for the volatile commodities markets, traders now use the ATR indicator for other markets too. Like Forex and major global indices.
Basically, it calculates the total price range including gaps for a trading day. The smaller the price difference, the smaller the number. The higher the total trading range, the higher the ATR number.
Then, an ‘average true range’ is calculated over a given period. Generally, the time frame used is somewhere between 5 and 14 days. However, most traders tend to use a ten day time frame.
Each trader can then modify this to suit themselves. Murray adds his own twist. He takes the ATR number and divides it by the price, so he ends up with an average true range over ten days as a percentage of the price.
He then lays the indicator over the top of the market being analysed and inverts the scale for the ATR indicator. This means that as the ATR indicator rises on the chart, volatility falls and vice versa.
Let’s look at an example…
In a rising market, the ATR percentage will be quite low. Look at the chart below. On the left hand side of the chart, the numbers are percentages. So 1.0 is actually 1% and so on.
Around December 2010 (on the left of the chart), you can see the ATR percentage indicator rising. The ATR indicator is well below 1.0 (remember the scale is inverted so a rising line means falling volatility). In fact, the price range for each trading day during this period is roughly around 0.7%. This suggests that the market wasn’t particularly volatile at this point.
But look how much things changed a few months later in late July and early August 2011 (in the middle of the chart). It moves from 1.5% to as high 3.3%. It’s this ‘drop’ on the chart that tells a trader that volatility is increasing.
There’s a simple way to remember how it works. When the market rises, the ATR percentage indicator range falls. That is, it shows a low number. When the market’s falling, the ATR range will increase. And you’ll see a much higher percentage number.
So how does this tell you what’s happening in the market now?
If you look at the far right of the chart, you can see that over the last few weeks, the S&P500 has tried to rally.
Yet, as Murray told his Slipstream subscribers earlier this week, it’s because of this chart he’s still ‘bearish’ on the market overall.
‘Sure the S&P 500 has attempted to rally. But at the same time, the volatility is increasing. Look, the ATR percentage indicator is hovering around 1.5%. It’s because of this rising volatility that I can remain bearish on the market.’
Simply put, he uses the indicator to either confirm or to question the current market movements. He looks at the relationship between the indicator and the market being studied. So when a divergence opens up between the two (when the indicator and market ‘separate’) it can be a great warning sign that a reversal may be imminent.
It’s important to remember when using indicators, that they are just that. An indication of what might happen. Murray finds the ATR percentage indicator useful to his technical analysis, but it’s not his only way of ‘reading’ the market. In fact, he has his own propriety technique. But he uses other technical tools, like the ATR indicator, to confirm a trade.
If you’d like to see how Murray is using this analysis to predict the next big market move, click here to learn more.
Shae Smith
Editor, Money Weekend
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