Last updated on April 26th, 2020
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.
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.
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.
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.