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, over a given time frame. The indicator has multiple uses for day traders. It aids in the placement of orders, has intraday tendencies, and can be used as a trailing stop loss.
Examining the ATR Indicator
The ATR indicator moves up and down as price moves in an asset become larger or smaller. The indicator is based on price moves, so the reading is a dollar amount. For example, an ATR reading of 0.23 means that the price moves $0.23, on average, each price bar. In the forex market, the indicator will show pips, where a reading of 0.0025 means 25 pips.
A new ATR reading is calculated as each time period passes. On a one-minute chart, a new ATR reading is calculated each minute. On a daily chart, a new ATR is calculated each day. All these readings are plotted to form a continuous line, so traders can see how volatility has changed over time.
Because the ATR is based on how much each asset moves, the reading for one asset isn't compared to other assets in isolation. For example, an ATR reading of 0.50 may seem high if the stock is priced at $10, but on a stock priced at $100, an ATR of 0.50 may be considered low. It is because if the price moves $0.50 on a $10 stock, that represents a 5 percent price move. A $0.50 move on a $100 stock represents a 0.5 percent price change.
To understand the indicator better, here is how it is calculated.
Finding the A, or the average first requires finding the True Range (TR).
The TR is the greatest of the following:
- Current high minus the previous close
- Current low minus previous close
- Current high minus 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 each day, and then an average is taken. If the ATR is averaged over 14 time periods, then the formula is as follows:
- ATR = [(Prior ATR x 13) + Current TR] / 14
How ATR Can Aid in Trading Decisions
The ATR describes how much an asset typically moves over the course of the day. Day traders can use this information for plotting profit targets and determining whether a trade should be taken on.
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 daily range (high minus low) is at $1.35. The price has already moved 35% more than the average. Assume the trader gets 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. The chart shows this in action.
Since the price is already up substantially and has moved more than 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, in this case, is often the better choice assuming a valid trade signal occurs.
Entries and exits should not be based on ATR alone. ATR is a tool that is used in conjunction with a strategy to help filter trades. For example, in the situation above, a trader 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 the trader's strategies, would ATR help confirm the trade.
The opposite could also occur if the price drops, 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 it should be avoided or taken 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. A strategy buy signal is required in order to buy in this case, as ATR is not acted on alone.
Look at the historical daily ATR readings as well. ATR is not static, so even though the price may be trading beyond the current daily ATR, based on history the movement may be quite normal.
Day Trading ATR Tendencies
If using the ATR on an intraday chart, such as a one- or five-minute, the ATR will spike higher right after the market opens. For stocks, when the major U.S. exchanges open at 9:30 a.m. the ATR moves up. This is because when using a one-minute chart the indicator is tracking how much each one-minute bar moves. Since the open is the most volatile time of day, ATR moves up to show that volatility is higher than it was at yesterdays close.
After the spike at the open, 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 (if using a one-minute chart). In the same way the daily ATR was used 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 ten minutes. It may help establish profit targets or stop loss orders.
If the ATR on the one-minute chart is 0.03, then the price is moving about $0.03 per minute. If a trader forecasts the price to rise, and they buy, they can expect that the price is likely to take at least five minutes to rally $0.15. This type of analysis aids in formulating expectations about what is likely or unlikely to occur. Traders sometimes think that as soon as they enter a trade, the price will magically surge to their profit target. Studying ATR shows the real movement tendencies of the price. 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.
ATR changes and often declines throughout the day, but ATR still provides a good estimation of how far we can expect the price to move and how long it could take.
ATR Trailing Stop Loss
A trailing stop loss is a way to exit a trade. Assume you take a long trade and the price is rising as you expect. A trailing stop loss gets you out if the price drops by a certain amount. In other words, it reduces risk or locks in a profit as the price moves in your favor.
ATR is commonly used as a trailing stop loss. At the time of the trade, look at the current ATR reading. Place a stop loss at a multiple of the ATR. Two is common multiple, meaning you place a stop loss at 2 x ATR below the entry price if buying, or 2 x ATR above the entry price if shorting.
The stop loss only moves to reduce risk or lock in a profit. If long, and the price moves favorably, continue to move the stop loss to 2 x ATR below the price. 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. The stop loss is only moved down.
For example, a long trade is taken at $10, and the ATR is 0.10. Place a stop loss at $9.80. The price rises to $10.20, and the ATR remains at 0.10. The stop loss is now moved up to $10, which is 2 x ATR below the current price. When the price moves up to $10.50, the stop loss moves up to $10.30, locking in at least a $0.30 profit on the trade.