ATR (Average True Range)

Introduction

It’s interesting to note the various indicators that the stock market has to offer.

No matter what the situation is, you can be sure that there is something that can discern what you want and give you the opportunity to explore various strategies and trading styles.

You have the RSI, MACD, EMAs, SMAs, and whatnot, but here, we’ll instead direct our attention to the ATR, i.e., the Average True Range.

What is ATR (Average True Range)?

So, what exactly is the ATR supposed to be? Well, it’s a technical indicator that first saw mention way back in 1978.

he man behind it is known as the “father of several technical indicators,” at least according to Wikipedia. He’s also behind the RSI, aka the Relative Strength Index, and that is quite a popular one too. As for its underlying purpose, let’s look at that below.

The Purpose of ATR

So, what was the ATR made for really? Well, it’s a price volatility indicator displaying an asset’s average price variation within any given time period.

Investors may use this indicator to gauge the most optimal time for trading. Not only that, but the ATR also accounts for the gaps within the asset’s price movements.

In other words, there’s no trend bias, and it can be a decent tool for volatility risk management.

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How is ATR Calculated?

The ATR functions by generating the true range’s average; what is the true range now? It’s simply the classic way of measuring the asset price’s range of movement.

In contrast, that average true range is simply a smoothed MA, or moving average of those true range values, and this is how it seeks to make evaluating volatility much simpler and accessible for traders.

Formula for True Range (TR)

So, based on what has been said earlier, calculating the average true range first requires calculating the true range itself.

This may be done by acquiring the biggest of the following three calculations:

• Current high minus Current low
• Current low minus Previous close
• Current high minus Previous close

Formula for ATR

An average is then calculated for those recorded values of every period, with the number of periods being 14. This produces the average true range’s value.

That initial 14-period ATR value is calculated with the method we explained above, but for subsequent 14-period ATRs, you have the following formula being used:

Current Average True Range = [Prior Average True Range * 13 + Current True Range] / 14

Key Parameters of ATR

While the ATR calculation is based on 14 periods, the period may be daily, intraday, weekly, or even monthly.

For instance, you have a new ATR being calculated each day on daily charts and each minute on minute charts.

Once plotted, the readings assume the shape of continuous lines that display the volatility changes over time.

How to Use ATR in Trading

So, now that you have a bit of an idea regarding ATR and what it’s supposed to do, you might want to know how you may use it in some actual trading.

Outlined below are a couple of examples of that.

Setting Stop-Loss Levels with ATR

Among the most worthwhile applications of ATR is setting some stop loss levels. After all, preventing losses is vital to managing risk since it limits losses within any trade.

Putting a stop outside key resistance and support levels helps circumvent premature exits from trades and allows for more dynamic stop-losses while simultaneously avoiding tight stops.

All in all, with ATR and its volatility-based reference, knowing where to put stops may no longer be that much of an issue.

Measuring Market Volatility

But how do you actually measure volatility using this thing? To start with, higher ATR values imply that the asset is a more volatile one, with lower ATR values obviously suggesting the exact opposite, i.e., lower volatility with reduced price fluctuations.

But since there’s different ways to interpret things, here’s how you may contextualize those values.

So, simply compare historical ATR values with current ones to see if volatility is higher, relatively speaking. And you can even compare those values to similar assets.

ATR and Trend Following

Interestingly enough, there’s another popular technical indicator known as the ATR Trailing Stops, and as you guessed from its name, it’s derived from the ATR indicator itself, but it’s designed with a more specific goal in mind.

This has to do with enabling traders to set stop-loss levels with price volatility factored in. So, if that ATR Trailing Stop falls below the price, then it implies an upward trend, giving traders the signal to maintain those long positions.

However, if it’s above the price, then it suggests a downward trend, encouraging those short positions.

If a crossover occurs between the price and the trailing stop, then you might have a possible trend reversal, being an opportunity to exit or enter a trade.

ATR Strategies for Different Trading Styles

 Let’s shift our attention to ATR and how it relates to some of the popular trading styles that you see traders using, namely day, swing, and long-term trading.

Day Trading with ATR

Day trading seems to revolve a lot around short-term gains, and trades usually last only a couple of days, hence the term “day trading.”

So, how can day trading apply to ATR? Firstly, they may try using shorter time frames to suit their needs and just avoid choppy or sideways markets, i.e., markets that have little action going on with price’s remaining mostly stable with hardly any room for making significant gains.

Swing Trading with ATR

Unlike day trading, swing trading focuses heavily on medium-to-long-term gains, and with that, more options open up that may not be readily available to day traders.

For instance, you can benefit more from trend reversals since you will give yourself more time to work with.

So, with ATR in the equation, you can adjust your time frames to medium settings and set up positions where you’re more poised to benefit from trend reversals.

Long-Term Investing with ATR

As for long-term investors, well, they have considerably more room to work than either day or swing traders.

So, they can set their time frames as they see fit, which will naturally be longer. However, because of that, they may be making themselves more open to risks pertaining to volatility.

So, with ATR, they may use it as a sort of portfolio risk management tool, i.e., a way to stop their losses from reaching unacceptable levels.

One way you can go about doing this is using a trailing stop order in conjunction with the ATR indicator.

Advantages and Limitations of ATR

Like with any market indicator you have nowadays, there will be pros and there will be cons. And focusing on both is integral to making the most of your stock trading.

Benefits of Using ATR

Starting with the pros, the ATR indicator is a simple tool to familiarize yourself with. It’s not all that complex, and getting a hang of it shouldn’t take too long.

Other than that, it’s a versatile indicator and can be good for managing risks too, since it focuses on tracking price volatility.

Limitations of ATR

On to the cons now: ATR happens to be a lagging indicator, which means that it responds to price changes that have already happened.

This lag might limit its efficacy within rapidly evolving or extremely volatile markets. While it does offer data regarding volatility, other insights like market sentiment, future trend direction, and more aren’t provided.

And finally, because of its nature as a volatility indicator, it won’t really do well in flat markets. After all, what good is a volatility tool within a market that has little to no volatility?

Conclusion

To summarize, the value that ATR brings as an indicator tool can be significant if its potential is fully tapped.

But there are shortcomings, like false signals and more, that will be a hindrance, so it’s best used with other indicators for additional confirmation or effective gauging of market sentiments.