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How Average True Range (ATR) Can Improve Your Trading
Use this volatility measure to improve order placement and market analysis.
Average true range (ATR) is a volatility indicator that shows how much an asset moves, on average, during a given time frame. The indicator can help day traders confirm when they might want to initiate a trade, and it can be used to determine the placement of a stop loss order.
Examining the ATR Indicator
The ATR indicator moves up and down as price moves in an asset become larger or smaller. A new ATR reading is calculated as each time period passes. On a one-minute chart, a new ATR reading is calculated every minute. On a daily chart, a new ATR is calculated every day. All these readings are plotted to form a continuous line, so traders can see how volatility has changed over time.
To calculate the ATR by hand, you must first calculate a series of true ranges (TRs). The TR for a given trading period is the greatest of the following:
- Current high minus the previous close
- Current low minus the previous close
- Current high minus the current low
Whether the number is positive or negative doesn’t matter. The highest absolute value is used in the calculation.
The values are recorded for each period, and then an average is taken. Typically, the number of periods used in the calculation is 14.
J. Welles Wilder, Jr., who developed the ATR, used the following formula for subsequent periods—after the initial 14-period ATR was completed—to smooth out the data:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
How ATR Can Aid in Trading Decisions
Day traders can use information on how much an asset typically moves in a certain period for plotting profit targets and determining whether a trade should be attempted.
Assume a stock moves $1 a day, on average. There is no significant news out, but the stock is already up $1.20 on the day. The trading range (high minus low) is 1.35. The price has already moved 35% more than the average, and now you’re getting a buy signal from a strategy. While the buy signal may be valid, since the price has already moved significantly more than average, betting that the price will continue to go up and expand the range even further may not be a prudent decision. The trade goes against the odds.
Since the price is already up substantially and has moved more than the average, the price is more likely to fall, staying within the price range already established. While buying once the price is near the top of the daily range—and the range is well beyond average—isn’t prudent, selling or shorting is probably the better choice, assuming a valid sell signal occurs.
Entries and exits should not be based on the ATR alone. The ATR is a tool that is used in conjunction with a strategy to help filter trades. For example, in the situation above, you shouldn’t sell or short simply because the price has moved up and the daily range is larger than usual. Only if a valid sell signal occurs, based on your particular strategy, would the ATR help confirm the trade.
The opposite could also occur if the price drops and is trading near the low of the day and the price range for the day is larger than usual. In this case, if a strategy produces a sell signal, you should ignore it or take it with extreme caution. While the price may continue to fall, it is against the odds. More likely the price will move up and stay between the daily high and low already established. Look for a buy signal based on your strategy.
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You should review historical ATR readings as well. Even though the stock may be trading beyond the current ATR, based on history, the movement may be quite normal.
Average True Range — ATR Definition
What is Average True Range — ATR?
The average true range (ATR) is a technical analysis indicator that measures market volatility by decomposing the entire range of an asset price for that period. Specifically, ATR is a measure of volatility introduced by market technician J. Welles Wilder Jr. in his book, «New Concepts in Technical Trading Systems.»
The true range indicator is taken as the greatest of the following: current high less the current low; the absolute value of the current high less the previous close; and the absolute value of the current low less the previous close. The average true range is then a moving average, generally using 14 days, of the true ranges.
- Average true range (ATR) is a technical indicator measuring market volatility.
- It is typically derived from the 14-day moving average of a series of true range indicators.
- It was originally developed for use in commodities markets but has since been applied to all types of securities.
Calculating Volatility with Average True Range
The Formula For ATR Is
The first step in calculating ATR is to find a series of true range values for a security. The price range of an asset for a given trading day is simply its high minus its low. Meanwhile, the true range is more encompassing and is defined as:
How To Calculate ATR
Traders can use shorter periods than 14 days to generate more trading signals, while longer periods have a higher probability to generate less trading signals. For example, assume a short-term trader only wishes to analyze the volatility of a stock over a period of five trading days. Therefore, the trader could calculate the five-day ATR. Assuming the historical price data is arranged in reverse chronological order, the trader finds the maximum of the absolute value of the current high minus the current low, absolute value of the current high minus the previous close and the absolute value of the current low minus the previous close. These calculations of the true range are done for the five most recent trading days and are then averaged to calculate the first value of the five-day ATR.
What Does Average True Range Tell You?
Wilder originally developed the average true range (ATR) for commodities, but the indicator can also be used for stocks and indices. Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR. The ATR may be used by market technicians to enter and exit trades, and it is a useful tool to add to a trading system. It was created to allow traders to more accurately measure the daily volatility of an asset by using simple calculations. The indicator does not indicate the price direction; rather it is used primarily to measure volatility caused by gaps and limit up or down moves. The ATR is fairly simple to calculate and only needs historical price data.
The use of the ATR is commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the «chandelier exit» and was developed by Chuck LeBeau. The chandelier exit places a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade.
Average true range can also give a trader an indication of what size trade to put on in derivatives markets. It is possible to use the ATR approach to position sizing that accounts for an individual trader’s own willingness to accept risk as well as the volatility of the underlying market. (For a detailed example on how to use ATR for this purpose, read our article, Sizing A Futures Trade Using Average True Range.)
Example Of How To Use ATR
As a hypothetical example, assume the first value of the five-day ATR is calculated at 1.41 and the sixth day has a true range of 1.09. The sequential ATR value could be estimated by multiplying the previous value of the ATR by the number of days less one, and then adding the true range for the current period to the product. Next, divide the sum by the selected timeframe. For example, the second value of the ATR is estimated to be 1.35, or (1.41 * (5 — 1) + (1.09)) / 5. The formula could then be repeated over the entire time period.
Limitations Of ATR
There are two main limitations to using the average true range indicator. The first is that ATR is a subjective measure — meaning that it is open to interpretation. There is no single ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead, ATR readings should always be compared against earlier readings to get a feel of a trend’s strength or weakness.
Second, ATR also only measures volatility and not the direction of an asset’s price. This can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points. For instance, a sudden increase in the ATR following a large move counter to the prevailing trend may lead some traders think the ATR is confirming the old trend; however, this may not actually be the case.
2 Ways To Use Average True Range (ATR) For Better Trading
The Average True Range indicator measures the volatility of a market and that information can help us do several things.
We can decide:
- If a market is volatile enough to trade when compared to its recent past
- What price to enter on a breakout
- Where our stop loss should rest
- Where to trail our stop to let the market run to larger profits.
At Netpicks, one of our constant themes is to hammer home the importance of managing your risk. Without risk management that protects your capital, you are only one losing streak away from flame out.
What Exactly Is The ATR Indicator
As mentioned earlier, the ATR indicator measures the price movement of an instrument. Knowing how far a price can move during an intra-day session is good information for day traders. It makes no sense to enter directional trades if the instrument has already surpassed its average range for the day.
Day traders who start at the beginning of a session can determine, in advance, what their expectations should be in terms of profit potential for the day by noting the current reading of the average true range. Of course anything can happen in a market but having a baseline is a great start and traders can monitor price action if they see a higher volition day shaping up.
Declining ATR = Smaller price moves
The calculation involves two steps with the first one finding the true range of the instrument:
- Current High minus current Low
- Current High less previous Closing price
- Current Low less previous Closing price
For a 14 period ATR setting which is the default, the last calculation is: Current ATR = [(Prior ATR x 13) + Current TR] / 14.
You should not compare that ATR reading of one instrument to another. Each reading should be standalone information for the instrument you are trading.
From the final ATR number, we can see if an instrument is becoming more or less active when compared to the recent past – and this includes small time frames such as 5 minute charts up to the large time frames.
Knowing if you are looking at an instrument that is showing lack of price movement can help you determine if this is a market you will trade. Some traders will determine that the low ATR reading is a great time to look for a trading range and then will monitor for a break out.
Other traders will see a falling ATR reading on an instrument as lower profit potential and lack of momentum due to the lack of market volatility.
There is no right or wrong meaning to your decision of what the ATR reading is. The key is to be consistent in your approach and everything should be contained within a tested trading plan and used with a trading strategy that has an edge in the market.
2 Important Uses Of Average True Range Indicator
There are a few different methods of using the ATR (even as a stand alone trading strategy) but I want to hit on two things that you can start testing today. You can see immediate positive results when applying these two techniques.
Let Your Profits Run
One of the easiest things for a trader to do is to hit close when they see decent profits on their trade. This is common among undisciplined traders and those that have long losing streaks.
Exiting your trade when the market still has momentum and potential is just as bad as letting your losing trades run. We want to milk as much as we can from the market until we see signs of a change of character.
One use of ATR is as a trailing stop and the logic is that if the market moves adversely against you in line with average range of the market, you may be seeing a shift in the underlying driver of the instrument.
Crude Oil – Day Trading – 14 ATR
On this chart I have added a 14 period ATR to the bottom and on the price portion, this indicator calculates the price point for the trailing stop. For short trades, the calculation is from the close of the candlestick plus 2 X ATR.
In this example, we have a basic trading strategy of breakout/pullback in the context of a down trend. You can see if you sold in the range or at the breakout, price fell strongly to the downside.
The ATR trailing stop is calculated at every candlestick close which allows you to take advantage of this move until adverse price action takes you out. The plus side to the exit is you are being taken out when the rally is showing strength to the upside after the down move has exhausted the current trend direction run.
Set Stop Loss At Objective Price Points
Setting your stop loss is vital to protecting your capital. While some traders will keep a mental stop, the main point is that knowing where to exit when price is pulling against you is vital.
The key is to find a place on the chart that:
- Takes into account the momentum in the market
- Allows for the ebb and flow of price movement
- Exits your trade, perhaps at a loss, when trading conditions are not optimal
The way to do it is to use a multiple of the ATR to set your stop loss. By doing so, you are respecting the volatility of the market and are not keeping a tight stop simply to increase your position size.
Stop Loss – Initial 2 X ATR
The first setup is a pullback trade to previous resistance for this example. What you should see is the trailing stop ATR is too close to price so we would need to use the ATR from the indicator window below.
- Assume you enter on the green candlestick with the arrow
- Calculate 2 X ATR
- Take the closing price of the candlestick and subtract the ATR result
Something to consider…..
When considering ATR, we are referring to a range of price where highs and lows are used in the calculation. You will have to determine, using this example, whether you would use the closing price of the candlestick or the high in the case of a buy trade setup.
There will be times where there is not much of a difference in the price.
On the right side, considering a breakout trade, the stop location using the 2 X ATR plus the closing price of the candlestick with the arrow, is close to the trailing stop ATR.
Is ATR Right For You?
It does not matter whether you day trade or swing trade, having an objective measure of the volatility of an instrument can go a long way in how you engage with the market.
Trailing your stops is something that many traders do and often times they will use price structures such as support or resistance.
As I wrote about here in regards to failure tests and trapped traders, price can breach these zones without invalidating the trade. You will be taken out of the trade at the exact moment you should be entering.
We can not argue that letting your winners keep on amassing profits until the market changes character is the only way to get alpha.
If you are trading without an initial stop loss, you are flirting with disaster. Knowing where you will exit if the trade does not get positive feedback soon after entry, is key to managing your risk and protecting your trading account.
Using an ATR stop helps keep you out of the random fluctuations of the market until the trade gets in gear. You don’t have to wait until the stop gets hit if you are seeing strong price action against you which could simply mean you were too early on the trade entry.
Regardless of your use of the average true range indicator, knowing the range of your instrument can help you decide whether to keep it on your list of instruments or set it aside until the market wakes up again.
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