The average true range is a technical indicator that measures volatility of a market based on the range and price movement of the market. It is purely derivative of price, unlike something like implied volatility.
The indicator was developed by technical analyst Welles Wilder and showcased in his groundbreaking 1978 book New Concepts in Technical Trading Systems, which also introduced now ubiquitous technical indicators like the Relative Strength Index and the Average Directional Index.
In a nutshell, Average True Range is a moving average of true range, hence the name. The true range calculation aims to determine the range of a trading session using OHLC data. Here is the formula to calculate true range:
Once you have the true range value, you must choose a lookback period, Wilders suggests 14 days, and apply a moving average to the set of values. Because self-calculating indicators is completely unnecessary nowadays, we won’t go too deep into this, however, it is important to know what calculations an indicator is making, and whether those readings mean anything.
Quantifying Risk and Average Fluctuations
Average true range is used by millions of traders and investors to quantify, in terms of price volatility, how much risk they’re exposing themselves to over periods of time. For example, long term value investors might be interested in looking at the ATR of a monthly chart even if they are not trading. It would indicate what normal fluctuations in positions might look like, and which fluctuations are above average and may require a deeper look at the situation.
Below is a daily chart of the S&P 500, as you can see, the daily ATR is currently at 37. That tells us, that, on average, the S&P will move in a range of about 37 points on a given market day. This gives traders and investors terrific insight, as sometimes they don’t know how to distinguish real market moves from market noise and range-trading. When they open their S&P index fund account and see it down 19 points, there should be no reason for alarm (at least from a standpoint of price and ATR), as 19 points is well within the expected daily range of 37 points.
Setting Stop Losses
Like we mentioned earlier, the ATR gives us an idea of the average market fluctuations for the period we set it to. We can use these levels to set stop losses.
Let’s say we are day trading S&P 500 futures on a 5 minute chart. We find an entry we like, but we don’t know where to set our stop loss. Well, for most strategies, an ATR-based stop loss can work wonders, because we’re setting our stop based on a quantitative level of how much the market moves on average, not based on where we want to get out of the market.
If our ATR-based stop loss is hit, that indicates that the market is making a larger than average move against our entry, and that we’re probably wrong on the trade.
The multiplier of ATR you use to determine your stop loss should be based off how wide your profit targets are, and how long your time horizon is.
For example, if it’s a scalp trade that you don’t plan to be in for longer than 10 minutes, than a 3x ATR stop loss is not ideal. Conversely, if you’re trying to catch a larger upswing in price and plan to hold for a few days, a 0.5x ATR stop loss isn’t ideal either.
In the scalping situation, the stop is likely too wide, as your losers will be large while your winners will be very small. In the swing trade situation, if you plan to be in the trade for longer than a day, the price is very likely going to hit your stop loss, because you based it on half of an ATR on a short term chart. Setting such a tight stop for a longer time horizon trade like this would be going against the reason the ATR indicator was created.
The same methodology for using ATR stop losses could be applied to set a profit target. This is based on the same principle, that setting stops and targets based on a quantitative level derived from price data is likely to lead to better results than “eyeballing” your stops and targets.
Let’s look at another trade example. Assume you’re trading an intraday mean reversion system. You get a signal when the price moves outside of your Keltner Channels. Your system says you should use a 1.5x ATR as a stop loss. In this situation, with you executing your short position at 2765.00, your stop loss is $5.44, rounded up to the nearest tick, is $5.50 away from your price, 2770.00. What should your profit target be?
Assuming your stop loss is 1.5 ATRs away from your entry, and considering you’re trading a mean reversion system, it might be smart to have similar profit target. Perhaps around the moving average, or “mean,” which the price should ideally revert back to, which is 2 ATRs away from your entry.
Essentially, there is no “one-size-fits-all” approach to using the ATR indicator. It is simply a tool in your toolbox which you can use to better manage your trading. The use of the indicator all depends on the type of trading you are doing, your time horizon, the assets that you’re trading, market conditions, etc.
However you use it, it is sure to stop you from making some bad trades in the future. The placement of quantitative, rules-based stops and targets compared to qualitative, “eyeballing” based stops and targets is sure to show an improvement in your trading over a large number of trades. It can even be the difference between being profitable and losing money.