Which Volatility Measure? by Gordon Gustafson
Is it true? Is average true range, an approximation, superior to standard deviation, the most beloved of quants, as a measure of volatility?
Many traders use some measure of volatility to
generate signals in their trading. For instance, one common entry technique is to buy when the price breaks outside a certain range of the volatility of the recent price action, either to the upside for trend following or below for countertrend systems. Another common use for volatility is in the construction of trailing stops. An exit signal might be generated when the price falls below a recent low minus a measure of volatility.
In both cases, the rationale is that the price action has moved to such an extent that something is happening in the underlying instrument for reasons other than mere chance. But how, then, should the trader
Ideally, the indicator used should include within its range all price action that is the result of normal trading, so if the price moves outside the measure, we would know there is a reason to buy into or sell out of a position. While this might seem obvious, there are several factors to be considered here. For instance, is a volatility indicator good simply because it captures most of the price action? How can we tell which excursions are significant? Are all volatility measures created equal?