In his classic trading book “New Concepts in Technical Trading Systems”
Wells Wilder believed that most trading systems were broken down into two basic
components, the first part focusing on the “technical trading system”
and the second part on money management or in his words “capital management
technique”. For the majority of these systems, Wilder believed that they all
had one vital missing component which was that they did not tell traders “what
and when” they should trade. Not surprisingly, the answer to the first part
of this issue, Wilder believed traders should focus on trading on trending markets.
What Wilder did do that was unique to his time, was that he developed trading methods
that helped traders to identify if and how strong a market was trending or not trending
by using his Directional Indicator or Average True Range (ATR) indicator. Let’s
take a closer look at the ATR and see how it can help you improve your trading decisions.
Wilder defined volatility as the maximum range that the price moved. He described
the price movement as the true range. True range is calculated either during the
day or from prior days close to the extreme point reached during the day. Wilder
defined true range as the greatest of the following:
- The distance from today’s high to today’s low.
- The distance
from yesterday’s close to today’s high, or
- The distance from yesterday’s
close to today’s low.
- The range of a day's trading is simply high −
In order to account for limit up or limit down downs associated with commodities,
the true range formula extends its calculation to include the prior day’s
closing price if it was outside of today's range. By making this adjustment any
gaps in price would also be accounted for in the ATR formula. Wilder felt that the
true range needed to be an average figure if one wanted the ATR to be more meaningful
indication of volatility. Many traders typically use 14 or 7 periods to calculate
In Wilder’s original Volatility system, he used 7 periods in his calculation.
Keep in mind that as with most indicators you’re encouraged to test which
period works best to fit your style of trading.
It’s important to note that the true range formula calculates an absolute
change in price, so that the true range reflects absolute changes in volatility
and not a stock’s exponential change. This basically means that lower price
stocks will have lower absolute changes in true range versus absolute change in
higher priced stocks.