Enter Profitable Territory With Average True Range

The indicator known as average true range (ATR) can be used to develop a complete trading system or be used for entry or exit signals as part of a strategy. Professionals have used this volatility indicator for decades to improve their trading results. Find out how to use it and why you should give it a try.

Key Takeaways

• Average true range (ATR) is a tool that helps traders notice when a stock might make a big shift; not specifically the direction, but just that a change is occurring.
• Traders use ATR to catch breakout opportunities and set volatility-based exit points to preserve gains and limit losses.
• Unlike fixed-percentage stops, ATR adjusts to each stock’s unique volatility, making it flexible for different types of trading techniques.

What Is ATR?

The average true range is a volatility indicator. Volatility measures the strength of the price action and is often overlooked for clues on market direction. A better-known volatility indicator is Bollinger Bands.

In “Bollinger on Bollinger Bands” (2002), John Bollinger writes, “high volatility begets low, and low volatility begets high.” The chart below focuses solely on volatility, omitting price, so we can see that volatility follows a clear cycle.

How close together the upper and lower Bollinger Bands are at any given time illustrates the degree of volatility the price is experiencing.

We can see the lines start out fairly far apart on the left side of the graph and converge as they approach the middle of the chart. After nearly touching each other, they separate again, showing a period of high volatility followed by a period of low volatility.

Bollinger Bands are well-known and can tell us a great deal about what is likely to happen in the future. Knowing a stock is likely to experience increased volatility after moving within a narrow range makes that stock worth putting on a trading watch list.

When the breakout occurs, the stock is likely to experience a sharp move. For example, when Hansen Natural Corporation, which has since changed its name to Monster Beverage Corporation (MNST), broke out of the low volatility range in the middle of the chart (shown above), it nearly doubled in price over the next four months.

The ATR is another way of looking at volatility. Below, we see the same cyclical behavior in ATR (shown in the bottom section of the chart) as we saw with Bollinger Bands. Periods of low volatility, defined by low values of the ATR, are followed by large price moves.

Understanding Trading With ATR

The question traders face is how to profit from the volatility cycle. While the ATR doesn’t tell us in which direction the breakout will occur, it can be added to the closing price, and the trader can buy whenever the next day’s price trades above that value. This idea is shown below.

Trading signals occur relatively infrequently, but usually spot significant breakout points. The logic behind these signals is that whenever the price closes more than an ATR above the most recent close, a change in volatility has occurred. Taking a long position is betting that the stock will follow through in the upward direction.

ATR Exit Sign

Traders may choose to exit these trades by generating signals based on subtracting the value of the ATR from the close.

The same logic applies to this rule; whenever the price closes more than one ATR below the most recent close, a significant change in the nature of the market has occurred. Closing a long position becomes a safe bet because the stock is likely to enter a trading range or reverse direction at this point.

The use of the ATR is most commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the chandelier exit and was developed by Chuck LeBeau.

The chandelier exit places a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade.

The value of this trailing stop is that it rapidly moves upward in response to the market action. LeBeau chose the chandelier name because “just as a chandelier hangs down from the ceiling of a room, the chandelier exit hangs down from the high point or the ceiling of our trade.”

Important

ATR is unique in that it is not concerned with the direction of a stock’s movement, but rather how significant that movement is, helping to spot momentum early.

The ATR Advantage

ATRs are, in some ways, superior to using a fixed percentage because they change based on the characteristics of the stock being traded, recognizing that volatility varies across issues and market conditions.

As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader’s desire to protect profits with the necessity of allowing the stock to move within its normal range.

ATR breakout systems can be used by strategies of any time frame. They are especially useful as day trading strategies. Using a 15-minute time frame, day traders add and subtract the ATR from the closing price of the first 15-minute bar.

This provides entry points for the day, with stops being placed to close the trade with a loss if prices return to the close of that first bar of the day. Any time frame, such as five minutes or 10 minutes, can be used.

This technique may use a 10-period ATR, for example, which includes data from the previous day. Another variation is to use multiple ATRs, which can vary from a fractional amount, such as one-half, to as many as three. (Beyond that, there are too few trades to make the system profitable.) 

In his 1990 book, “Day Trading With Short-Term Price Patterns and Opening Range Breakout,” Toby Crabel demonstrated that this technique works on a variety of commodities and financial futures.

Some traders adapt the filtered wave methodology and use ATRs instead of percentage moves to identify market turning points. Under this approach, when prices move three ATRs from the lowest close, a new up wave starts. A new down wave begins whenever the price moves three ATRs below the highest close since the beginning of the up wave.

How Will I Use This in Real Life?

As a trader, ATR can help you make informed trading decisions by indicating when a stock’s price is moving more than usual. If, for example, a stock’s price fluctuates by $5 during a trading day, and all of a sudden it’s fluctuating by $10, it’s a signal that something may have changed.

This can help you make entry and exit decisions on your trades based on the volatility of the price, adding context to the movements rather than making decisions based on false breakouts or reversals that might just actually be standard market fluctuation.

ATR can also help you manage risk. When you know how volatile a stock is, you can adjust your trading strategy to your risk tolerance level, making your trading decisions more logical than emotional.

What Is the Difference Between Technical Analysis and Fundamental Analysis?

Technical analysis relies on historical price data and chart patterns to help traders make trading decisions and is generally suited for day trading and other similar strategies that have a shorter time frame. Fundamental analysis, on the other hand, is better suited for long-term investments and focuses on a company’s financials, such as its balance sheet and income statement, to make investment choices.

What Are Common Technical Analysis Indicators?

Some of the most common technical analysis indicators include Bollinger Bands, Relative Strength Index (RSI), Stochastic Oscillator, Moving Average Convergence Divergence (MACD), and Fibonacci Retracements.

What Does the Average True Range Tell You?

The average true range (ATR) is a technical indicator that tells you the volatility of a stock on average over a given period. It doesn’t convey the direction of the stock’s price, but just how much the price has moved. It helps traders avoid low-volatility environments (more volatility means better chances for profits), set stop losses, and avoid false breakouts.

The Bottom Line

The possibilities for this versatile tool are limitless, as are the profit opportunities for the creative trader.

It is also a useful indicator for long-term investors to monitor because they should expect times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods of time.

They would then be ready for what could be a turbulent market ride, helping them avoid panicking in declines or getting carried away with irrational exuberance if the market breaks higher.