Trading using AVERAGE TRUE RANGE

Overview

The Average True Range (“ATR”) is a measure of volatility. It was introduced by 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 RSI or slow stochastic.

 

Calculation

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

Above Daily chart of Apple shows the ATR.

 

Average true range does not indicate the direction of the market, but simply the volatility. 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 enter or exit the market accordingly. For example, a daily stop-loss may be set at 1.5 or 2 times the average true range. This gives an asset price freedom to vary naturally during a trading day, but still sets a reasonable exit position.

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

Interpretation

Wilder has found that high ATR values often occur at market bottoms following a

“panic” sell-off. Low Average True Range values are often found during extended

sideways periods, such as those found at tops and after consolidation periods. As seen in below chart of S&P 500 High ATR was seen during bottoming out period of market as marked by Red  Arrows.  When market goes in sideways zone ATR reduces as marked by Yellow arrows.

 

Trading using Average True Range Indicator

 

ATR breakout and Breakdown systems

 

ATR is very useful in identifying great short set up using classical technical analysis. As seen in below chart of Amazon, Stock broke its up trending Trend line when a price is declining and then breaks below  its trend line, it is a potential SELL/SHORTING signal. When the ATR also breaks above its own resistance it confirms the price break lower, since it shows strong movement in the downward direction. A stop should also be placed on each trade to as part of risk managment. Typically a stop is placed below a recent low when taking a long position, or above a recent high when taking a short position.

 

We have discussed this on the AMAZON daily chart. The price breaks aggressively below its  a upward  trend line with gap down. When the price breaks lower, the ATR also breaks its resistance line confirming the price will fall lower. Stop can be placed at the recent high of 840.  Stock corrected all the way till 720 from 790 and formed bottom when ATR peaked around 20.

 

As seen in below chart of American Express, Stock broke its down trending Trend line with a gap up when a price is declining and then breaks above its trend line, it is a potential LONG/BUY signal. When the ATR is also trading at higher end it confirms that bottom is in place and Longs can be initiated with Low of the gap up candle as Stop loss. AXP went into consolidation zone after this big gap up prices even came near the stop loss but did not trigger and the big rally started once the consolidation was over. Stock Rallied  all the way till 77 from 67.

 

 

The above 2 examples show how the ATR can help confirm trades by looking for a jump in ATR and ATR at Higher end  as the price breaks resistance or support. For these trades, traders can look to exit profitable trades using a predefined target, trailing stop or other technical analysis method.

 

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 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.

 

Conclusion

 

ATR  can be used to confirm entries as well as act as a stop and/or trailing stop. 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 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 way with irrational exuberance if the market breaks higher. Use ATR to determine when volatility is increasing and when it is contracting; this can help determine the best times to trade.