How Average True Range (ATR) Indicator Strategy Can Help You in Trading
Technical indicators help traders get insights into the price movements of assets whose prices constantly fluctuate. One such indicator is the ATR indicator which comes in handy in measuring the volatility of an asset. Traders use ATR indicators to make better investment decisions.
Let’s understand what an ATR indicator is and how to use it in your trading strategy.
What is the ATR Indicator?
The Average True Range (ATR) indicator is a technical indicator used in trading. The indicator measures the volatility of an asset’s price, i.e., the variation in the average price of an asset over a given period.
The Average True Range indicator is created on a candlestick chart. It is a moving line which is plotted after calculating the true ranges. If the ATR has a higher value, the asset has a high level of volatility. The contrary is true if the ATR indicator has a low value.
How was the Average True Range (ATR) Indicator Invented?
The ATR indicator was invented by J. Welles Wilder, a technical analyst who is also credited to have invented the Average Directional Index (ADX) calculator.
Wilder invented the indicator to use in conjunction with the ADX indicator so that the momentum and the volatility of an asset’s price can be easily measured.
Also Read: How to use Aroon Indicator to Spot Early Trends in Trading
The Average True Range (ATR) Formula
The ATR formula is straightforward, but you need to use various preliminary steps to formulate the final ATR calculation formula. Let’s understand –
- First, you need to find the true range values of the asset. On the other hand, the true range values are calculated as the difference between the current high and the last close, plus the difference between the current low and the last close.
- Secondly, a time period is determined which is, usually, 14 days.
- The ATR indicator is then plotted as a moving average of the true range values over the determined time period.
The ATR formula is as follows –
ATR = (1/n) ∑TR over the ‘n’ period
TR is the true range and ‘n’ is the time period which is 14.
To calculate the TR, the following formula is used –
TR = Maximum of the following values –
- (High – Low)
- Absolute high – closing price
- Absolute low – closing price
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How to Calculate the Average True Range (ATR)
To calculate the ATR, here are some simple steps that you can take –
- Find the true range of each day of the chosen time period. For instance, you want to calculate the ATR of the last 10 days, you would have to find the true range of each day starting from day 1
- The average of the true range of the said time period would give you the ATR of the first day.
- To calculate the ATR for the next day, the formula is as follows –
Current ATR = {previous ATR * (n-1) + TR} / n
- This way you can calculate the ATR of each day over the chosen time period and then plot the ATR indicator line on the chart.
Let’s understand this with an example:
Suppose the first-day ATR of a stock is 2.5 and you want to calculate the ATR over five days. The true range on the sixth day is 2.3.
The next day ATR would be calculated as follows –
Current ATR = {previous ATR * (n-1) + TR} / n
= {2.5 * (5-1) + 2.3} / 5
= 2.46
You can then use the same formula to calculate the ATR over the next three days.
To use the ATR, add the ATR value to the stock’s closing price on the last day. You can buy the stock if the stock price rises above this value.
The logic is if the price closes more than the recent ATR, volatility has occurred. As such, you can take a long position on the stock.
How to Interpret the ATR?
You can use the ATR to determine when to enter and exit the market. A higher value of ATR means high volatility and a low value means the opposite. So, if the ATR is rising, the asset is turning volatile.
However, if the ATR value remains low for a continuous period, it indicates a trend reversal or consolidation.
The indicator measures the volatility if there are gaps in the asset’s prices and they move up or down. Traders use the ATR to enter or exit a trade. Sharp changes in ATR values indicate abnormal price rise of fall giving traders the signal to enter or exit.
Average True Range Strategy in Trading
You can use the ATR values to make good trades in the market. For example, if the price of a stock rises above the ATR values, it can indicate a buy signal. However, if the price has increased above the ATR, you should also know that it might not rise further in the future.
Moreover, if the price has increased considerably over the ATR value, it might also fall. As such, you can either indulge in day trading to cash in on the rising prices or short sell.
Even in the case of profit booking, the ATR indicator strategy can be used. If the market has a low volatility as depicted by lower ATR values, you can place a closer profit booking level.
If the volatility is high, the level can be put further away to make maximum profits.
Also Read: What are Momentum Indicators? How do they Help Traders?
Ways to Use the ATR for Stop Loss
The ATR trading strategy is most helpful in stopping loss trades. As such, many use it for fixing the ATR trailing stop loss points. At high ATR values you know that the asset is experiencing price volatility.
As such, you can place your stop loss value at a higher level so that you don’t exit the asset prematurely. Alternatively, if the ATR value is falling and is low, you can put a stop loss value at a closer level so that you can exit the trade early on and avoid losses. So, use the ATR stop loss strategy to exit a bad trade and cut your losses.
Final Word
The ATR indicator helps formulate profitable trading strategies and fix your stop loss levels. However, the indicator lags and might not allow you to catch early trends.
ATR indicator is subjective, and you need other indicators, along with the ATR indicator, to get the right insights. For instance, the ADX indicator works well with the ATR indicator to tell you when to enter and exit the market.
So, understand the ATR indicator, how it works, and its limitations. Use it with other technical indicators when trading in stocks, indices or commodities and make profitable trading decisions.
FAQs
Ans. The indicator indicates an asset’s price volatility and how much it is expected to move.
Ans. No, the time duration of 14 days is not fixed. It is used as a standard period but you can pick any period based on which you aim to design your trading strategy.
Ans. If you want to measure only volatility, you can use the ATR indicator in conjunction with Bollinger Bands that also measure volatility.
Ans. The ATR trailing stop is a strategy wherein you set trailing stop loss levels based on the ATR values. If there are wider stops, it means that the volatility is high. If the stops are lower, it means that the volatility is low.
Ans. No, they are not the same. Trailing stops when the price of the asset moves. However, stop loss is a fixed level which does not move even when the price moves.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
