The average true range indicator could be a new arrow in your quiver of technical analysis tools.
New traders often tell us that they feel good about their entries, but just don’t know when to get out of trades. Unfortunately, such statements typically stem from large losses. This inevitably leads to a conversation about what many people consider the No. 1 rule of the trading jungle: Control thy risk. Easier said than done, right? Small losses can often be made up, but large, uncontrolled losses really hurt. One way to help control your losses is to use an indicator such as average true range (ATR). Adding ATR to your charts can assist you in calculating where to put your stop orders or other exit points.
Before we get down to the nitty-gritty of how some have used the ATR indicator, let’s discuss some basics. It was first introduced by a mechanical engineer turned technical analyst named J. Welles Wilder in his 1978 book New Concepts in Technical Trading Systems. At its heart, ATR is a volatility indicator, and it’s pretty straightforward. Over the course of a day (or any period for that matter), a stock’s “true range” is defined as the higher of:
In essence, we’re trying to figure out how much movement might occur from one time period to the next. For example, a stock might fluctuate on average $2 a day, but the range of a day, week, or month typically exceeds that. Because there can be a fair amount of volatility with true range, the indicator looks at the average of the true range to help smooth things out.
So, how do you apply ATR? First, set your parameters. And with ATR, there are two:
A trader using an ATR indicator strategy might place a stop order $4 below the entry point. If the initial trade is profitable, and as the ATR changes, the trader might adjust the stop order such that it’s always 2x the ATR.
Setting the parameters is a matter of personal choice, but part of the decision may rest with a trade’s expected time horizon or its “posture.” The following table shows how you might use the ATR concept for several trading postures.
The position trader is likely to “ride the trend” up and down during a stock’s cycle as long as the trend is intact. Swing trading would be trading the up or down movements within the stock’s cycle. Why might the swing trader use a shorter lookback period? The ATR is designed to help smooth out daily fluctuations, so a long lookback might cause the swing trader to miss out on some, well, swings.
Let’s go through a trend trading example. In figure 1 you’ll see a price chart with an ATR (14) study applied. It appears just below the price graph.
The current ATR (14) is $2.05, meaning that over the last 14 days this stock fluctuated, on average, $2.05 from one day to the next. As a result, if you bought the stock at its current price and you used a multiplier of 2x, you might set an initial stop at $4.10 (that is, 2 x $2.05) below the entry price.
Seriously, that’s it. No complex formulas here. So the next time you’re feeling out in the cold with your exit strategy, maybe you’ll find some warmth with the average true range approach.
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