In this tutorial, you will learn how to use the Average True Range.
The ATR is very simple to calculate:
The Current Period High minus (-) Current Period Low
The Absolute Value (abs) of the Current Period High minus (-) The Previous Period Close
The Absolute Value (abs) of the Current Period Low minus (-) The Previous Period Close
true range=max[(high – low), abs(high – previous close), abs (low – previous close)]
The Average True Range is an essential technical indicator for a trader. We use ATR in many trading systems for different purposes.
ATR to measuring volatility
Firstly, the Average True Range calculates the price’s historical volatility. The volatility is cyclical; it moves from low value to high value constantly.
So, using the ATR helps you to predict a price move. Newbie traders analyze only the price; with volatility, you can go deeper. It’s like watching a 3d film!
You can use it to analyze many markets and many instruments. This indicator is born for commodities, but immediately traders used it for all markets.
It’s handy for automated trading systems but also discretionary traders.
Everyone has to consider the volatility associated with a given financial instrument before entering a trade.
In the stock market, when an uptrend is genuine, the Average True Range is declining.
Remember that when the market crashes, the ATR rockets up.
It’s easier to predict volatility than the price.
Your trading systems will love the Average True Range because it can easily calculate the position size.
When volatility is high, you always have to reduce your market exposure.
It’s straightforward. You have only to decide your stop loss in money, suppose 200$.
Now you divide 200$ by X times the ATR value. For example, the ATR(10) is 2$; you have to divide 200$ by 10$ (2$ x 5 times). The result is the number of contracts to buy.
Remember that when the market rises, the ATR declines, and your position increases. The problem is that you have a big position, probably near a downturn.
Generally, the market decline fast and sharply so pays attention! Never over-increase your position size during low volatility phases.
ATR to set your stop loss
Your stop loss has to be volatility-responsive. When the market is nervous, and the volatility is high, you can’t set a small stop loss.
Especially if you’re using trend follower strategies, you have to stay in a trade for a long time.
The system is straightforward; you can add X times the ATR value to the price.
Generally, we like to use multiple ATR. In this way, you could exit with a “scaling out strategy,” or you could set a multiple stop loss.
Moreover, you could modify the ATR value for uptrend phases and downtrend phases. The ATR should be less responsive in a downtrend. In fact, you have to avoid a big stop loss in a volatile market.
The Average True Range is also handy to calculate your trailing stop. Many times you have to stay in a position for a long period.
Your trailing stop has to be volatility-responsive like your stop loss. The trading system could calculate the trailing stop every day and adapt it with the volatility.
Usually, when you add a trailing stop to your system, the profit decreases. Nevertheless, many traders like to use it; it’s only a psychological issue.
We like to use a trailing stop only if the system doesn’t get too bad.
If you are an intraday trader, you can use the ATR. Remember that the ATR increases in the first part of the day and decreases for the rest.
It’s useless to calculate the volatility, but it’s useful to set the stop loss and one intraday trailing stop.
Anyway, the indicator works better on a daily chart.
Calculate the ATR Direction
Your trading system must track the direction of the Average True Range. Using a simple moving average, the system can understand if volatility is trending up or down.
When the ATR line stays above the moving average, the trend is up and vice-versa.
You know that the moving averages are lagging. If you want to know what’s happening fast, you need to “slope” the ATR.
We like to slope many indicators; practically, we compare today’s ATR value with the past.
How to Filter the ATR
Maybe you would like to use the ATR to scan the market. In this manner, you can find the most volatile instruments. The problem is that the indicator value changes based on the instrument price.
A stock that quotes at 100$ has a bigger ATR respect of a stock that quotes 2$.
To compare ATR from different instruments, you have to standardize the output value.
How to do this? For example, you can use the distance from a moving average. The stock that has the ATR value far from its moving average is in the high volatility phase.