Trading the average true range

The Average True Range (ATR) is a measure of volatility that was introduced by J. Welles Wilder in his book, “New Concepts in Technical Trading Systems” in 1978, and has since been used as a component of many indicators and trading systems. 

The average true range indicator is an oscillator, meaning the ATR will oscillate between peaks and valleys. The ATR has no upper or lower limit bounds like the classical technical indicators: Relative Strength Index (RSI) or slow stochastic. 

The ATR is comprised of three inputs, which are helping identify the volatility of a security. To determine the level of volatility there are three ranges included in the equation.

  1. Current Day’s Range: The distance from today’s high to today’s low.
  2. How high has the security risen from the previous day’s close? The distance from yesterday’s close to today’s high.
  3. How low has the security dropped from the previous day’s close? The distance from yesterday’s close to today’s low.

The highest value of the three inputs is the ATR.

The Average True Range is a moving average (typically 14-days) of the true ranges. 

The average true range is an exponential n-day average, and can be approximated by this equation.

Average true range does not indicate the direction of the market, but simply the volatility (see “Measuring volatility,” below). The equation gives the most recent price movement greater significance; hence, it is used to measure market sentiment.

It is usually used to analyze the risk of taking a specific position in the market. One way of doing this is to predict daily movements based on historic values of ATR, and to enter or exit the market accordingly. It is often used as a way to calculate stop-loss and profit targets. For example, a daily stop-loss may be set at 1.5X or 2X the ATR. This gives an asset price freedom to vary naturally during a trading day, but still sets a reasonable exit position. Depending on a trader’s timeframe, a move beyond current ATR levels would indicate a change in market trend. 

Moreover, if the historic ATR contracts while prices are trending upwards, then this might indicate that market sentiment may turn.

Interpretation

In addition to using average true range as a way to set profit and stop-loss targets, ATR can be used as a market signal. Wilder has found that high ATR values often occur at market bottoms following a “panic” sell-off. Low ATR values are often found during extended sideways periods such as those found at tops and after consolidation periods. “Buying opportunities” (below) shows recent examples from when the S&P 500 had high ATRs. During bottoming out periods of market activity the ATR rose. When the market goes in sideways zone ATR falls. 

ATR breakouts and breakdowns

Average true range is very useful in identifying great short setups using classical technical analysis. As seen in “Breakdown” (below), Amazon (AMZN) breaks through a support level, which is validated by a similar break in the ATR. Amazon broke its upward trending trendline on Oct. 28, 2016, which is a potential shorting signal. When the ATR breaks above its resistance line about a week later it confirms the signal. Notice that Amazon rebounded and tested the trendline after the initial break and sold off further as the ATR resistance was broken. A stop should be placed on each trade as part of a risk management strategy. Typically, a stop is placed below a recent low when taking a long position, or above a recent high when taking a short position.

A trader would have shorted Amazon at $784 on Nov. 8. A stop can be placed above the trendline break at $801 or at the recent high of $840. Amazon fell all the way to $720 and bottomed when ATR peaked around 20. 

American Express (AXP) broke its down trending trendline with a gap up opening on Oct. 20, 2016 creating a potential buy signal (see “Buying range,” below). With the ATR also trading at a four-month high, it confirms that a bottom is in place and longs can be initiated. The low of the gap-up candle can set as a stop loss level. The long would have been initiated at $66.47 on the open following the gap. AXP went into consolidation zone after this big gap-up and came near the stop loss but did not trigger it. It rallied as high as $78 and is still on. Traders may consider raising their stop. 

These two examples show how the ATR can help confirm trades by looking for a jump in ATR that corresponds with another technical trigger. For these trades, traders can look to exit profitable trades using a predefined target, trailing stop or other technical analysis method. 

The ATR advantage

ATR is, in some ways, superior to using a fixed percentage because it changes based on the characteristics of the underlying market being traded, recognizing the fact 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 limitations

Interpreting ATR is subjective. There is no level that indicates a stock is about to reverse, or that a trend will continue. Rather, current ATR readings must always be compared to prior readings to get a sense of trend strength or weakness.

ATR also doesn’t factor direction, only volatility. This can sometimes result in confusing signals at market turning points. A spike in the ATR following a big counter-trend move may make traders think the ATR is expanding to confirm the old trend. This is not the case, though. The new price information reveals a big price reversal, 
so ATR is confirming that, not the old trend.

ATR can be used to confirm entries as well as to calculate appropriate stop levels. ATR doesn’t look at direction; it is up to the trader to determine whether expanding or contracting ATR values confirm recent price moves. It is also a useful indicator for the long-term investors to monitor because they should anticipate times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods. 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. 

ATR should not be used as a standalone signal, but is valuable in confirming moves and in timing trades. Use ATR to determine when volatility is increasing and when it is contracting; this can help determine the best times to trade.

About the Author

Bramesh Bhandari is a proficient stock trader at Indian stock market.He share his insight in Forex,Commodity and World Indices through his site http://www.brameshtechanalysis.com.