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The Average True Range (ATR) is a technical analysis indicator developed by J. Welles Wilder in the 1970s. If his name rings a bell, you might’ve seen it mentioned on another article. It turns out that Wilder actually developed several other well-known indicators, including the Relative Strength Index, Directional Movement and the Parabolic Stop and Reverse.
The ATR measures the degree of price volatility, which can provide interesting implications in any market. Without movement and volatility, price wouldn’t move. Being able to see the progression of this volatility over time helps numerous traders adjust to changing market conditions.
In this article, we’ll take a look at the Average True Range indicator in depth, and perhaps it will make its way into your strategy in one way or another.
Understanding How the ATR Indicator Works
The ATR indicator does not provide directional signals, unlike other technical indicators like moving averages or RSI. Instead, it measures the average range that an asset’s price moves over a specified period.
This information helps traders gauge market volatility and make decisions themselves, either using another indicator or other signal their strategy produces.
Calculating the ATR
This indicator is calculated by first determining the True Range (TR) for each period.
The TR is the greatest of the following three values: the difference between the current high and low, the difference between the current high and previous close, or the difference between the current low and previous close. Once the TR is calculated for a specific number of periods (typically 14), the ATR is calculated by taking the average of these TR values.
The ATR can be calculated using various techniques, such as simple moving averages, exponential moving averages, or Wilder’s smoothing method. Traders often use software or trading platforms to calculate the ATR automatically, saving time and reducing the risk of calculation errors.
Interpreting the ATR
The ATR is a measure of volatility, with higher ATR values indicating greater volatility and larger price swings. When the ATR is rising, it suggests that volatility is increasing, and traders may expect more significant price fluctuations. Conversely, a falling ATR indicates that volatility is decreasing, and price movements may become more subdued. It’s essential to note that the ATR does not provide any information about the direction of the market, only its volatility. Traders often use the ATR in conjunction with other technical indicators to assess market conditions and make informed trading decisions.
Using the ATR Indicator in Your Day Trading Strategy
Depending on your approach and how much you rely on technical indicators, the ATR could provide numerous benefits to any trading strategy.
Keep in mind that no single indicator provides everything necessary to trade successfully. Traders use a combination of indicators, tweaking their settings to fit their philosophy.
Maybe you just want to focus on controlling position size dynamically, using smaller size when the market gets too volatile, and larger size when it’s too calm. On the other hand, you might find that the ATR helps you set more precise exit conditions for your stop losses and profit targets.
Let’s take a look at how the ATR can help with all three of these things.
ATR-Based Position Sizing
It should be a bit self-explanatory that adjusting position size according to volatility can result in more consistent profits. When the market is too hectic, using a smaller position size is something many traders already do. But using the ATR specifically for this can turn a general idea into a more systematized approach, which is almost always better.
A common method is to determine the position size based on a fixed percentage of the trader’s account balance and the ATR. For example, a trader might risk 1% of their account balance per trade and adjust their position size accordingly, depending on the current ATR value.
Consider the following formula.
Position Size = (Account Risk / ATR) * ATR Multiplier
Decide the percentage of your account balance you’re willing to risk on each trade. If you have a $10,000 account, and you’re willing to risk 1% per trade, the math is easy. Your account risk on any single trade should be $100 ($10,000 * 0.01).
Then, determine the ATR value. Having the indicator on the chart makes this even easier. Let’s assume the ATR is 4. So in each candle, you’re expecting a 4 point swing at worst, on average.
Choose an ATR multiplier. This is a factor that determines how far away your stop-loss and position size will be from the current price. It’s commonly between 1-3, so let’s use 2. You can adjust this based on your risk tolerance and strategy.
Calculate position size: Use the formula mentioned above to calculate the position size. In our example, the position size would be (100 / 4) * 2 = 50.
In other words, because the ATR is a bit high here, the formula is determining that you should cut your position size down to 50, to maintain the same level of risk you’re accustomed to.
ATR-Based Stop Losses
When determining your stop loss or profit target with the ATR, you can use a similar philosophy.
If you’re buying at $100, your typical stop loss might normally be 1%, or at $99. But the risk at 1% on Monday isn’t always the same as 1% on Tuesday, even if both entries are at $100. This is when the ATR can improve your trading strategy’s reliability.
A common method is to set the stop-loss a multiple of the ATR away from the entry point. If you want a wider stop-loss, you can employ a higher ATR multiplier. When the market is particularly volatile, it’s more likely that your tighter stop loss will not survive a longer move.
ATR-Based Profit Targets
Just like when setting dynamic stop losses, you can use an ATR multiplier to pick a better profit target. Using a strict 1% rule will result in missing out quite a lot on days where the market is trending more violently.
Profit Target = ATR * 5
Imagine your profit target follows this formula above. To take a profit of 10 points, you determine that it would take about 8-10 candles, assuming the market roughly 2 points per candle.
Then, one day, the ATR shows a value of 6. Using this information, you might adjust your profit target, using the ATR multiplier, to something like 25 or 30 points, instead of 10. Rather than increasing your size to earn more, you’ve simply adjusted your approach based on the volatility of the market at that moment.
When the market begins moving in your direction, you will capture a more significant part of the move, rather than just 1 or 2 candles worth, by being aware of the changed volatility.
ATR Limitations
As with any indicator used in a vacuum, the ATR has some limitations. But compared to other indicators, it’s significantly lighter and should not be used completely alone when developing a comprehensive trading strategy.
Lack of Price Direction Insight
The ATR is a purely volatility-based indicator. You won’t get any information about what price is actually doing, besides the fact that it’s fluctuating more or less than usual. As a result, use other indicators like the MACD or RSI, or other price action analysis to gather information on direction.
Sensitivity to Sudden Spikes
Depending on the time period used, ATR values can be heavily influenced by sudden, large price swings or gaps. If you have a trade setup that gets triggered during one of these moments, the extreme price movements may lead to potentially skewed calculations in your trade. Consider using a longer lookback period or having a technique to reduce the impact of these situations.
Lagging Indicator
As with most technical indicators, the ATR does not predict the volatility of the next candle. Traders can use it to make semi-accurate inferences on the market based on its current condition, but you should be aware that it cannot provide a guarantee.
Mostly Useless in Low Volatility Markets
Did I say mostly? In a market without some reliable volatility and fluctuation, the ATR is closer to completely useless. Be sure you are not trading a market that likes to stay locked into a tight price range for days. Those markets do exist and have their purposes, but they are terrible for an indicator like the ATR.
Conclusion
The ATR is a useful tool for when markets seem to be going through a particularly chaotic period. We saw this happen during the 2016 election, when the volatility increased so much, that CME had to impose increased margin requirements across the board for futures contracts. It happened again when Covid-19 first began to spread in the US. The market volatility increased dramatically for a few weeks, and wreaked havoc on unprepared traders and tight stop losses.
In situations like these, it’s easy to see how being on top of the changes in volatility can bode well.
Not only does the ATR help traders adjust to changing markets, but it teaches the good habit of not making stops and profit targets too uniform. Markets don’t produce the same sized moves day by day. It’s better to adapt constantly, as day trading is just as much about survival as it is about making money.
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