How Average True Range (ATR) Can Improve Your Trading
A Volatility Measure for Better Order Placement
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 to attempt a trade.
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. The buy signal may be valid but, 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 and stay 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 a good option, assuming a valid sell signal occurs.
Entries and exits should not be based on the ATR alone. The ATR is a tool that should be used in conjunction with an overarching 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 sell signal based on your strategy.
You should review historical ATR readings as well. Even though the stock may be trading beyond the current ATR, the movement may be quite normal based on the stock's history.
Day Trading ATR Tendencies
If you're using the ATR on an intraday chart, such as a one- or five-minute chart, the ATR will spike higher right after the market opens. For stocks, when the major U.S. exchanges open at 9:30 a.m. ET, the ATR moves up during the first minute. That's because the open is the most volatile time of day, and the ATR simply indicates that volatility is higher than it was at yesterday's close.
After the spike at the open, the ATR typically spends most of the day declining. The oscillations in the ATR indicator throughout the day don't provide much information except for how much the price is moving on average each minute. In the same way they use the daily ATR to see how much an asset moves in a day, day traders can use the one-minute ATR to estimate how much the price could move in five or 10 minutes. This strategy may help establish profit targets or stop-loss orders.
Take your expected profit, divide it by the ATR, and that is typically the minimum number of minutes it will take for the price to reach the profit target.
If the ATR on the one-minute chart is 0.03, then the price is moving about 3 cents per minute. If you're forecasting the price will rise and you buy, you can expect the price is likely to take at least five minutes to rally 15 cents.
ATR Trailing Stop Loss
A trailing stop loss is a way to exit a trade if the asset price moves against you but also enables you to move the exit point if the price is moving in your favor. Many day traders use the ATR to figure out where to put their trailing stop loss.
At the time of a trade, look at the current ATR reading. A rule of thumb is to multiply the ATR by two to determine a reasonable stop loss point. So if you're buying a stock, you might place a stop loss at a level twice the ATR below the entry price. If you're shorting a stock, you would place a stop loss at a level twice the ATR above the entry price.
If you're long and the price moves favorably, continue to move the stop loss to twice the ATR below the price. In this scenario, the stop loss only ever moves up, not down. Once it is moved up, it stays there until it can be moved up again or the trade is closed as a result of the price dropping to hit the trailing stop loss level. The same process works for short trades, only in that case, the stop loss only moves down.
For example, say you take a long trade at $10 and the ATR is $0.10. You would place a stop loss at $9.80 (2 * $0.10 below $10). The price rises to $10.20, and the ATR remains at $0.10. The trailing stop loss is now moved up to $10. When the price moves up to $10.50, the stop loss moves up to $10.30, locking in at least a 30 cent profit on the trade. This would continue until the price falls to hit the stop-loss point.