Volume, ATR and Volatility Contraction
Use volume to confirm moves, calculate ATR by hand and recognise volatility contraction.
What you will learn
- How to use relative volume to judge a breakout.
- How to calculate true range and the average true range (ATR).
- How to use ATR for stop distance and position size.
- What volatility contraction is and why it often comes before expansion.
Explanation
Volume
Volume is the number of shares or contracts traded in a period. A breakout with clearly higher volume than usual shows more participation. Compare with the recent average: relative volume = today's volume ÷ average volume (for example of the last 20 days). Note: in spot forex and many CFDs there is no central exchange, so the platform often shows tick volume (number of price changes). It is only a rough substitute.
True range and ATR
The true range (TR) of a candle is the largest of three values:
- high − low
- |high − previous close| (the vertical bars mean "ignore the minus sign")
- |low − previous close|
The last two include gaps. The average true range (ATR), also developed by J. Welles Wilder, is the average TR over N periods, often 14. After the first value, Wilder's method smooths it: ATR new = (ATR old × (N − 1) + TR today) ÷ N.
ATR measures how much price usually moves. It says nothing about direction.
Volatility contraction
Volatility is the size of price movements. Periods of small candles and falling ATR (contraction) often come before larger moves (expansion). This is an observation about how markets alternate, not a timing tool: the direction and timing of the expansion are unknown. Triangles and flags from lesson 5 are often contraction phases.
Worked example
Hypothetical example: a share in €. Previous close before day 1: €50.00. We use a 5-period ATR to keep it short. Fees, spreads and taxes are excluded.
| Day | High | Low | Close | H − L | |H − prev C| | |L − prev C| | TR |
|---|---|---|---|---|---|---|---|
| 1 | 51.00 | 49.60 | 50.80 | 1.40 | 1.00 | 0.40 | 1.40 |
| 2 | 51.50 | 50.20 | 51.20 | 1.30 | 0.70 | 0.60 | 1.30 |
| 3 | 53.00 | 52.00 | 52.60 | 1.00 | 1.80 | 0.80 | 1.80 |
| 4 | 53.20 | 51.80 | 52.00 | 1.40 | 0.60 | 0.80 | 1.40 |
| 5 | 52.50 | 51.40 | 52.30 | 1.10 | 0.50 | 0.60 | 1.10 |
- Day 3 gapped up: the gap makes TR €1.80, not €1.00.
- ATR(5) = (1.40 + 1.30 + 1.80 + 1.40 + 1.10) ÷ 5 = €7.00 ÷ 5 = €1.40
- Day 6 has TR €2.00. Wilder update: (€1.40 × 4 + €2.00) ÷ 5 = €7.60 ÷ 5 = €1.52
Using ATR for a stop: entry at €52.30, stop 1.5 × ATR away: 1.5 × €1.40 = €2.10, so stop at €50.20. With €100 planned risk: €100 ÷ €2.10 ≈ 47.6, rounded down to 47 shares.
Volume check: the day-3 gap traded 720,000 shares; the 20-day average is 400,000. Relative volume: 720,000 ÷ 400,000 = 1.8.
Common mistake
Practice activity
Hypothetical: previous close $80.00. Next candle: high $78.50, low $77.00 (a gap down). Calculate the TR. Then, if ATR(14) was $1.50, calculate the new Wilder ATR.
Show solution
H − L = $1.50. |H − prev C| = |78.50 − 80.00| = $1.50. |L − prev C| = |77.00 − 80.00| = $3.00. TR = $3.00.
New ATR = ($1.50 × 13 + $3.00) ÷ 14 = ($19.50 + $3.00) ÷ 14 = $22.50 ÷ 14 ≈ $1.61.
Limitations: platforms use different smoothing methods, so ATR values can differ slightly.
Key takeaways
- Relative volume shows participation; tick volume is only a rough substitute.
- True range includes gaps; ATR is its average and has no direction.
- ATR helps size stops and positions consistently.
- Contraction often precedes expansion, but direction and timing are unknown.
Next step
In the next lesson you will draw Fibonacci retracements and extensions and learn to treat them as confluence, not magic.
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