The Average True Range (ATR) is a widely used technical indicator that measures market volatility. Unlike other indicators that focus on price direction, the ATR is all about understanding the magnitude of price movement. It’s particularly useful for setting stop-loss levels, gauging the strength of a move, and identifying potential breakout points. By understanding how to use ATR, traders can better manage risk and optimize their trading strategies.
What is Average True Range (ATR)?
The ATR was introduced by J. Welles Wilder in his 1978 book “New Concepts in Technical Trading Systems.” It is designed to measure the volatility of an asset by calculating the average range between the high and low prices over a specific period, usually 14 days. The “True Range” part of ATR considers the most significant of the following:
- The current high minus the current low.
- The absolute value of the current high minus the previous close.
- The absolute value of the current low minus the previous close.
The ATR is then calculated as a moving average of the True Range over the chosen period.
Understanding ATR in Plain Language
Let’s break down the concept:
- True Range:
- The True Range is the highest value among the three comparisons mentioned above. This ensures that gaps between closing and opening prices, which are often ignored by other volatility measures, are included.
- Average True Range:
- The ATR is simply the average of the True Range values over a set number of periods (typically 14 days). It gives you a sense of how much an asset’s price typically moves over that period.
Using ATR in Trading
ATR can be a valuable tool in several aspects of trading:
- Setting Stop-Loss Levels
- ATR-Based Stop-Loss: One of the most common uses of ATR is to set stop-loss levels. By using the ATR, traders can avoid setting stop-losses that are too tight and might be triggered by normal market noise. A common approach is to multiply the ATR by a factor (e.g., 1.5 or 2) and subtract it from the entry price in a long position, or add it to the entry price in a short position. This helps to place the stop-loss at a level that accounts for typical market volatility.
- Example: If you’re going long on a stock at $100 and the ATR is $2, you might set your stop-loss at $97 (entry price – 1.5 * ATR = 100 – 3).
- ATR-Based Stop-Loss: One of the most common uses of ATR is to set stop-loss levels. By using the ATR, traders can avoid setting stop-losses that are too tight and might be triggered by normal market noise. A common approach is to multiply the ATR by a factor (e.g., 1.5 or 2) and subtract it from the entry price in a long position, or add it to the entry price in a short position. This helps to place the stop-loss at a level that accounts for typical market volatility.
- Gauging Market Volatility
- Volatility Assessment: ATR is an excellent tool for assessing the volatility of a market or asset. A rising ATR suggests that volatility is increasing, which could indicate stronger price moves, while a falling ATR suggests decreasing volatility and potentially quieter markets. This information can help traders decide whether to enter or exit trades based on their risk tolerance.
- Identifying Breakout Points
- ATR and Breakouts: ATR can be used to confirm potential breakouts. When the ATR rises significantly from a low level, it suggests that a period of low volatility is ending and a breakout might be imminent. Traders can look for this signal to anticipate larger price movements.
- Trailing Stop-Loss
- ATR Trailing Stop: Some traders use the ATR to trail their stop-loss orders as the trade moves in their favor. This involves adjusting the stop-loss as the price moves, using a multiple of the ATR to determine how far behind the current price the stop should trail. This technique helps lock in profits while allowing room for the trade to develop.
- Example: If the ATR is $2 and you’re in a long trade, you might trail your stop-loss $3 behind the current price, adjusting it as the price increases.
- ATR Trailing Stop: Some traders use the ATR to trail their stop-loss orders as the trade moves in their favor. This involves adjusting the stop-loss as the price moves, using a multiple of the ATR to determine how far behind the current price the stop should trail. This technique helps lock in profits while allowing room for the trade to develop.
ATR Across Different Markets
ATR is not tied to a specific market or asset class—it can be applied to stocks, commodities, forex, and even cryptocurrencies. The flexibility of ATR makes it a valuable tool in any trader’s toolkit, regardless of the asset being traded.
Final Thoughts
The Average True Range is a simple yet powerful indicator that provides valuable insights into market volatility. By incorporating ATR into your trading strategy, you can better manage risk, set more effective stop-loss levels, and identify potential breakout opportunities. Remember, while ATR doesn’t provide directional signals, its ability to gauge the magnitude of price movements makes it an essential tool for understanding market dynamics.
Glossary
- True Range: The greatest of three possible values: the current high minus the current low, the absolute value of the current high minus the previous close, or the absolute value of the current low minus the previous close.
- Average True Range (ATR): A moving average of the True Range over a specified period, used to measure market volatility.
- Stop-Loss: An order placed to sell a security when it reaches a certain price, used to limit an investor’s loss on a position.