Key Takeaways
- The average true range (ATR) measures market volatility and how much an asset moves in a given time period.
- The time period used for ATR is often 14 days, though shorter periods can be used, too.
- ATR was developed by J. Welles Wilder, Jr.
- 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 astop-loss order.
How Does the Average True Range (ATR) Indicator Work?
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 on a graph to form a continuous line, so traders can see how volatility has changed over time.
To calculate an ATR for today, you must first calculate a series of true ranges (TRs).The TR for today would be the greatest number resulting from the following:
- Today's high minus yesterday's close
- Today's low minus yesterday's close
- Today's high minus today's low
Whether the number is positive or negative doesn't matter. The highest absolute value is used in the calculation. Once you figure out the highest value, you'll use that in your calculation. If you were looking at a 14-day period, you'd look at which 14 days of data had the highest numbers. Then you'd add them together and divide by 1/n, where n is the number of periods. This will give you the previous ATR, which you need for the calculation below.
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
Example of Using ATR in Trading
Day traders can use the information on how much an asset typically moves in a certain period for plotting profit targetsand determining whether to attempt a trade.
Let's assume you calculated out the previous 14-day ATR for stock ABC, and found that it is $2. Looking at the stock today, you gather the following information:
- Today's high = $32
- Today's low = $29
- Yesterday's close = $30
Now let's find the current true range by using the greatest value from these three calculations:
- $32 - $30 = $2
- $29 - $30 = -$1
- $32 - $29 = $3
We will use $3 since it's the highest. You can use this to determine the current 14-day period ATR to determine how volatile the stock may be.
Here's how the formula would look: (($2 x 13) + $3) / 14 = $2.07
There is no significant news out, but the stock is already up $3 on the day. The trading range (high minus low) is $3. The price has already moved 47% more than the average ($2.07), and now you're getting a buy signal from this 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 hasmoved 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 therange is well beyond average—isn't prudent, selling or shortingis probably a good option, assuming that a valid sell signal occurs.
Note
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.
Using ATR for Day Trading
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. Eastern, the ATR moves up during the first minute. That's becausethe 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 declines most of the day. 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 waythey 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.
Note
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.
For example, 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 that the price will rise, and you buy, you can expect that the price is likely to take at least five minutes to rally 15 cents.
Using Average True Range for a 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 on the trade 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, suppose you take a long trade at $10, and the ATR is 10 cents. You would place a stop-loss at $9.80 (2 * 10 cents below $10). The price rises to $10.20, and the ATR remains at 10 cents. 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.
Frequently Asked Questions (FAQs)
What does the average true range tell you?
The average true range (ATR) is a volatility indicator that gives you a sense of how much a stock's price could be expected to move. A day trader can use this in combination with other indicators and strategies to plan trade entry and exit points.
What is a good number to use for an average true range indicator?
The standard number to use with an ATR indicator is 14—as in 14 days—but that isn't the only strategy that works. If you want to place greater emphasis on recent levels of volatility, then you can use a lower number, which indicates a shorter period of time. Long-term investors may prefer to use a larger number to take a broader measurement.
