The average true range (ATR) is a volatility indicator that illustrates how much an asset moves on average over time. The indicator can be used by day traders to confirm when they wish to start a trade and to decide where a stop-loss order should be placed.
Taking a look at the ATR Indicator
As price movements in an asset become larger or smaller, the ATR indicator rises and falls. As each time period passes, a new ATR reading is calculated. Every minute, a new ATR reading is calculated on a one-minute chart. Every day, a new ATR is calculated on a daily chart. Traders can examine how volatility has changed over time by putting all of these values into a continuous line.
You must first create a set of true ranges to calculate the ATR by hand (TRs). The biggest of the following is the TR for a given trading period:
It makes no difference whether the number is positive or negative. In the calculation, the highest absolute value is chosen.
Each period’s data are recorded, and then an average is calculated. In most cases, 14 periods are employed in the calculation. After the initial 14-period ATR was completed, J. Welles Wilder, Jr. used the following algorithm to smooth out the data for succeeding periods:
((Prior ATR x 13) + Current TR) / 141 = Current ATR
How Can ATR Help You Make Trading Decisions?
For calculating profit targets and deciding whether to attempt a trade, day traders can use the information on how much an asset generally moves in a given period.
Assume that on average, a stock moves $1 every day. Despite the fact that no important news has been released, the stock has already gained $1.20 on the day. The trading range is $1.35 (high minus low). The price has already moved 35% more than the average, and a strategy has now given you a buy signal. Although the buy signal may be valid, given that the price has already moved much more than usual, wagering that it will continue to rise and expand the range any higher may not be a wise idea. Against all odds, the trade is made.
Because the price has already risen much and moved more than the average, it is more likely to decline and remain within the previously determined price range. While buying when the price is towards the top of the daily range—and the range is considerably beyond average—isn’t a smart idea, selling or shorting is usually a good idea if a valid sell signal appears.
The ATR should not be used to determine entry and departure points. The ATR is a technique for filtering trades that should be used in combination with a larger strategy.
In the case above, simply because the price has moved up and the daily range is higher than usual, you should not sell or short. The ATR will only help confirm the trade if there is a solid sell signal based on your approach.
If the price falls and trades near the day’s low, and the price range for the day is wider than typical, the opposite could happen. If a technique generates a sell signal in this instance, you should ignore it or proceed with caution. While the price may continue to decline, the odds are stacked against it. More than likely, the price will rise and remain between the previously established daily high and low. Based on your approach, look for a sell signal.
You should also look at previous ATR readings. Even if the stock is trading above or below the current ATR, the movement could be considered regular given the stock’s history.
Day Trading ATR Tendencies
The ATR will rise higher shortly after the market opens if you’re using it on an intraday chart, such as a one- or five-minute chart. When the major U.S. exchanges open at 9:30 a.m. ET, the ATR swings higher in the first minute for equities. The reason for this is that the open is the most volatile moment of the day, and the ATR simply reflects that volatility is higher than it was at yesterday’s close.
The ATR usually spends the majority of the day falling after the initial surge. The ATR indicator’s oscillations throughout the day don’t reveal much more than how much the price is moving on average each minute. Day traders can use the one-minute ATR to anticipate how much the price could fluctuate in five or ten minutes in the same way they use the daily ATR to evaluate how much an asset moves in a day. Profit targets or stop-loss orders may be established using this strategy.
Divide your predicted profit by the ATR, and you’ll receive the minimum number of minutes it’ll take for the price to achieve your profit target.
The price is moving roughly 3 cents every minute if the ATR on the one-minute chart is 0.03. If you predict that the price will rise and you buy, you may expect the price to rise 15 cents in at least five minutes.
A trailing stop loss
A trailing stop loss allows you to quit a trade if the asset price moves against you while also allowing you to move the stop loss point if the price swings in your favor. Many day traders utilize the ATR to determine where their trailing stop loss should be placed.
Examine the current ATR reading at the time of a trade. To find an appropriate stop-loss point, multiply the ATR by two as a rule of thumb. If you’re purchasing a stock, a stop loss at a level twice the ATR below the entry price can be a good idea. If you were shorting a stock, you’d set your stop-loss two times the ATR above the entry price.
If you’re long and the price advances in your favor, keep your stop-loss at twice the ATR below the current price. The stop loss only increases up in this circumstance, not down. Once it is raised up, it remains there until it can be moved up again or the trade is closed due to the price going below the following stop loss level. Short trades follow the identical procedure, only the stop loss only moves down.
Assume you enter a long trade at $10 with an ATR of $0.10. Stop loss would be set at $9.80 (2 * $0.10 below $10). The price increases to $10.20, but the ATR stays at $0.10. The trailing stop has been raised to $10. When the price rises to $10.50, the stop loss rises to $10.30, ensuring a profit of at least 30 cents on the deal. This would go on until the price dropped below the stop-loss level.