The Welles Wilder Volatility System

by Godswill Edet
October 1, 2024
3:01 pm

The Welles Wilder Volatility System is a commonly used tool to measure market movements. It was introduced by J. Welles Wilder Jr. in his book ‘New concepts in Technical Trading Systems‘, where he used the Average True Range (ATR) to measure volatility.

The ATR is a widely recognized indicator in technical analysis, often used to gauge the degree of price movement or volatility.

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Welles Wilder Volatility System

In Wilder’s Volatility Trading System, he uses 3 times the 7-day ATR to determine critical levels for generating buy or sell signals. This principle is also commonly applied in various trading strategies as a stop-loss mechanism.

In order to build the Wilder Volatility Trading System, you need to track the 7-day ATR, the highest high over the past 7 days, and the lowest low over the past 7 days. The rules are straightforward:

Buy Signal: When the price bounces from the 7-day lowest low by more than 3 times the ATR.
Sell Signal: When the price drops from the 7-day highest high by more than 3 times the ATR.

Learn how ATR is used in technical analysis. Ask the experts at Beo Forex Academy for in-depth explanations and examples from various trading resources.

Why Welles Wilders Trading Strategy is Important

Understanding the average true range (ATR) is crucial for several reasons and this includes:

Volatility Measurement: ATR helps traders gauge the level of market volatility. It provides a numerical value representing the average range between the high and low prices of an asset over a specific period.
Risk Management: By knowing the average range of price movements, traders can set appropriate stop-loss levels. This helps in avoiding premature exits due to normal market fluctuations.
Position Sizing: ATR can assist in determining the size of a position. In more volatile markets, traders might reduce their position size to manage risk better.
Identifying Breakouts: ATR can be used to identify potential breakout opportunities. A sudden increase in ATR might indicate a significant price movement, hence signaling a potential trade.
Consistency: Using ATR can lead to more consistent trading results by providing a clearer understanding of market behavior and helping to avoid unexpected price reversals.

Understanding Welles Wilders Volatility System Calculations and Formulae

Here’s a quick summary to reinforce your understanding of the Average True Range (ATR):

Define the True Range (TR):

- TR is the highest of:
  - The absolute value of the difference between the current bar High and the current bar Low.
  - The absolute value of the difference between the current bar High and the previous bar Close.
  - The absolute value of the difference between the current bar Low and the previous bar Close.

Calculate the ATR:

- ATR is the moving average of the TR.
- Wilder’s formula for ATR is: $\text{ATR} = \frac{(N-1) \times \text{Previous ATR} + \text{TR}}{N}$
- For a 14-day ATR: $\text{14-day ATR} = \frac{13 \times \text{Previous ATR} + \text{TR}}{14}$

This method helps smooth out the volatility and gives a clearer picture of market conditions.

Historical Volatility (HV)

The historical volatility measures the dispersion of returns for a given security or market index over a specific period. It is calculated using the standard deviation of price changes.

Here are a few key points about historical volatility:

Calculation: it involves determining the average deviation from the average price of a financial instrument over a given time period.
Usage: Traders use HV to guage how far a market can move, which helps in making price projections and placing orders.
Implications: High HV can indicate potential trend reversals due to heavy buying or selling, leading to sharp price movements.

In summary, the Welles Wilder Volatility System, centered around the Average True Range (ATR), offers traders a valuable tool for measuring market movements and managing risk.

By understanding ATR’s role in volatility measurement, risk management, position sizing, and also in identifying breakouts, traders can make more informed decisions and significantly improve their trading outcomes.