Bollinger Bands and ATR: measuring volatility

Not all markets move at the same pace. Gold can travel $40 in a day while EUR/USD moves 50 pips, and the same pair can be quiet one week and very choppy the next. Ignoring volatility means placing stops that are too tight when the market gets busy and targets that are too far when it is asleep. Two tools help you measure it: Bollinger Bands and the ATR.

Bollinger Bands

Bollinger Bands are made up of three lines. In the middle, a 20 SMA. Above and below, two bands placed two standard deviations away from that average. Standard deviation is a statistical measure of dispersion: the further recent closes stray from their average, the bigger it gets, and the wider the bands.

A common misconception is that price is "too high" when it touches the upper band. It isn't. In a strong trend, price can ride the band for long runs of candles. Touching a band only means the move is large relative to recent volatility.

The squeeze: the calm before the move

Markets alternate between quiet and busy phases. When the bands tighten sharply, to the point of reaching their narrowest width in several months, it is called a squeeze. This compression often comes before an expansion: price eventually breaks out of its narrow band with a bigger move.

• A squeeze signals a change in volatility, not a direction. The breakout can go up or down.
• The first breakout is sometimes a trap: price breaks one way, then rips back the other way.
• The trend on the higher timeframe helps you choose which side to favour.
• Squeezes often form ahead of a major release: check the economic calendar.

The ATR: the average range

The ATR (Average True Range) measures the average size of candles over a period, 14 by default. It is based on each candle's true range, which accounts for gaps: it is the largest of the following three values.

1. The candle's high minus its low.
2. The distance between the high and the previous close, in absolute value.
3. The distance between the low and the previous close, in absolute value.

The ATR is the average of these true ranges over 14 candles. It is expressed in the price's own unit: pips for a currency pair, dollars for gold, points for an index. It gives no direction, only the size of moves.

Placing a stop with the ATR

The most practical use of the ATR is the stop loss. A stop placed a fraction of an ATR away from your entry will be hit by simple market noise. A stop placed a reasonable multiple of the ATR away, beyond a technical level, gives the trade room to breathe. Many traders use a multiple of between 1 and 2 ATR, depending on their style.

The ATR also helps you stay consistent from one market to the next. A 20-pip stop can be wide on EUR/USD on a quiet day and tiny on GBP/JPY on a busy one. Thinking in ATR rather than fixed pips automatically adapts your technical risk to each situation.

The ATR is also useful for setting realistic targets. If EUR/USD's daily ATR is 60 pips and the pair has already travelled 70 pips since the open, aiming for another 50 pips in the same session requires an exceptional move. It is not impossible, but it is statistically less common. Comparing your target with the ATR stops you from letting a reasonable profit slip away while waiting for an out-of-reach target.

Finally, watch how the ATR itself evolves. An ATR that doubles in a few days signals that the market has entered a choppy phase: it is often the moment to reduce position size to keep the same cash risk, since the stop has to be wider.

Your turn: place a sensible stop on the chart below, taking both the technical level and volatility into account.