This is why having your eyes on volatility is so important and this is where, Average true range (ATR) comes to our rescue. Though I have already written post on a couple of volatility indicators- the Bollinger Bands and Donchian Channel, but what sets ATR apart from these is its value in managing risks while allowing traders to put stop-losses based on volatility.
In the paragraphs that follow, you would learn about this indicator. The article is crafted with beginners in mind, however, those who already know the indicator might find some part of the post informative as well.
Let's begin!
What is Average true range (ATR) indicator?
J. Welles Wilder, jr., the man behind RSI, ADX and Parabolic SAR, formulated this indicator and described it in his book New Concepts in Technical Trading.
An Average True Range (ATR) is a volatility indicator that measures how strongly (or weakly) the price of a stock is moving. Volatility is reflected through the range, the difference between the high and low prices of a stock in a particular period.
But ATR doesn't rely simply on highs and lows, it captures the gaps from the previous close apart from day's extremes, thus giving a comprehensive peek into the stock's volatility. This we will learn while discussing the calculation of the Average true range in the following paragraph.
How is Average true range (ATR) calculated?
Calculation of ATR involves three steps:
✔ Step 1- Calculation of True range-
True range is defined as the greatest value of the following three:
- Current high minus current low
- Current high minus previous close
- Current low minus previous close
Out of these three values, whichever value is maximum becomes the True Range value.
✔ Step 2- Calculation of first ATR value-
The first ATR value is simple average of a specified period. Since the default period for ATR is 14, so first ATR value is simply an average of True range of last 14 periods.
✔ Step 3- Calculation of subsequent ATR through formula-
Once you have got first ATR value (as in step 2), subsequent values are calculated through a formula as described below
ATR= [{ATR-yesterday * (N-1)} + TR-today] / N , where TR is true range.
This formula ensures the ATR responds quickly to sudden changes but doesn't flit on every random movement.
Now that we have understood the calculation behind the ATR values, let's now move on to the interpretation part.
How to interpret ATR indicator? -
An ATR is plotted below the price chart as a line that goes up or down based on price movements. This is shown in an image below.
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| Chart showing ATR below the Price chart |
An increasing ATR value suggests the volatility is increasing, that is, the price is moving more violently with the range of price candle increasing and a decreasing ATR value indicates price is moving gently within a range with smaller price bars or candles.
Bear in mind though, as highlighted in this article on ATR on Fidelity, the ATR has no directional bias. This means an increasing ATR only means volatility is increasing, but it doesn't tell you whether this volatility is in bullish direction or bearish direction. Simply put, an increasing ATR means price is swinging violently, it can be an upswing or a downswing.
See the chart below.
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| Chart showing low ATR during the period of low volatility when stock is rangebound and how ATR climbs up as the volatility increases after range breakout. |
Limitation of Average true range (ATR)
ATR is not an oscillator, as discussed earlier, this makes its values debatable and open for interpretation. ATR is both relative and subjective.
The word "relative" here means- being interpreted in comparison to other. So, when we are referring ATR to be 'high' we are comparing the ATR value with the preceding value. For example, in the chart above, The ATR can be interpreted as high on right-hand side, which essentially means it is greater than what it used to when the market was range bound.
The ATR is subjective as well. This means the values can be interpreted differently by two different analysts, depending on their trading preferences, and past experience.
Another limitation of ATR is, it has no directional bias as discussed earlier in the post. According to an article on ATR on investopedia, this limitation results in erroneous signals, especially when the market is near its turning point.
While ATR has some limitations- everything has, this doesn't mean it is not useful in stock trading. Next, we will get the hang of usage of ATR in trading.
How to use ATR indicator in trading?
Though ATR is most commonly used for risk management, however, this volatility indicator can be used in other settings as well. Let's learn this below.
To set Adaptive Stop-Loss- An adaptive stop-loss adjusts to the current volatility. So, when the stock is volatile, the stop-loss is wider to accommodate sudden counter swings, while during calm price movements the stop-loss is tighter.
This kind of stop-loss is calculated by first multiplying ATR by a certain factor- usually 1.5 or 2, and then calculating the stop-loss level by subtracting this value from close.
For example, if a stock's close is at ₹100 and ATR is 3.5 then
Stop-loss = 100 - (3.5*2) = 93.
To find Position size- Position size means number of shares you can buy of a particular stock and depends on your capital size, risk tolerance and stop-loss. Let's understand this through an example.
Let us suppose you have a capital of ₹ 1,00,000 and your risk tolerance is 1%. This means you can risk ₹1000 in one trade. Further let's assume you want to buy a stock trading at ₹200 with ATR value of 10.
So, your stop-loss would be (as discussed above) 200- (10 *2) = 180 and the risk you are taking per share is ₹20.
The maximum risk is ₹1000.
So, the number of shares (position size) would be- maximum risk/ risk per share, that is,
1000/20 = 50 shares.
This way you can use ATR to find position size for better risk management.
To confirm a breakout- You can also use ATR to confirm a breakout. If price goes past an established resistance level and ATR shows a spike of more than 1.5 times its previous level, it is strong signal that the breakout is genuine.
To find entry points in intraday trades- Many traders use ATR to find entry points in intraday trades. For example, some traders find the ATR and buy when the stock trades above (Previous close + ATR) level.
Another way traders use ATR in day trading is by applying ATR to smaller time frames like 30 minutes, 15 or 5 minutes. A popular tactic is to measure the range of the first 30 minutes and then use ATR to decide when to fade the initial spike or ride the breakout.
While every trader has his own way of using an ATR, the most popular usage of ATR is in managing risks by finding volatility based stop-losses and position sizing.
Final thoughts-
-ATR is a volatility indicator that measures the how violently (or calmly) a stock is moving.
-It incorporates previous close in its calculation, thus, also accounting for gap up and gap down openings and giving a complete picture of price movements.
-High ATR means a stock is volatile while a lower ATR reading means the stock is moving gently
-ATR doesn't have a direction bias.
-ATR is used in variety of ways but it is most often used in risk management like, placing stop-loss and finding position size.
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