In trading world, there are numerous technical indicators used by highly proficient technicians to find out direction and trend of market and potential buying or selling opportunities with the right level of entry and exit points to make your trade highly profitable at the lowest risk.
So these indicators can be generally classified into 2 major categories- 1. Long term 2. Short term. Here we can consider only shorter duration and that’s why technical indicators used intraday trading or day trading is in high demand. One of the most commonly used indicator in average true range indicator generally known as ATR. Lets discuss about this ATR, its uses, its accuracy, calculation in detail so that novice can easily use it at ease
What is the Average True Range Indicator in Trading?
The average true range (ATR) indicator is a very useful tool for technical analysis developed by J. Welles Wilder Jr. that you can use to measure the volatility of the market or individual underlying security. As a volatility indicator, it measures the strength of the price action of an underlying security for a specific period typically 14 days, that’s called the true range.
Also Read: How to Use Implied Volatility in Options Trading: Strategies
To be more precise ATR is more of a volatility indicator rather than a trend or directional. ATR not only considers the closing price difference but also the high-low range and the difference between the closing price and the previous day's closing price. When you incorporate these components, you can get more insight into the price movement of the underlying security, compared to just using the closing price difference.
How to Calculate Average True Range?
The calculation of the average true range might be challenging or complicated for traders, especially those who are novices in the market. For calculation purpose duration is solely depend on time frame you have taken. Some calculated ATR on the basis of daily and weekly while it can be calculated on the basis of intraday and monthly too. However, while plotting the true range period the readings from the continuous line showing the change represents the volatility over that time period.
Also Read: How to Trade in High Volatile Market: Best Trading Strategies
To find out the ATR value you have to go through the series of true ranges that need to be calculated. So first define a trading period and the actual range or you can say true range is the highest of absolute values computed by the given method-
- 1. Current high – Current low
- Current low – Previous close
- Current high – Previous close
Here the average is considered for recorded values of each period using the 14 period time range. This value is the average true range and the 14-period average true range value can be calculated using the procedure stated above. The subsequent 14-period average true ranges can be calculated with the formula given below.
Current Average True Range = [Prior Average True Range * 13 + Current True Range] / 14
True Range (TR) for Each Period: For each period, calculate the True Range (TR) using the formula given below:
- TR = Max (High - Low, |High - Previous Close|, |Low - Previous Close|)
- Here, "High" and "Low" signify the highest and lowest prices of the current period, and "Previous Close" refers to the closing price of the previous period. The absolute value (|) ensures positive values.
Average True Range (ATR): Once you have the TR values for your preferred period, calculate the ATR using the formula mentioned below:
- ATR = Average (TR for the past n periods)
- "n" represents the number of periods you count like 14 days. You can calculate the average manually or through charting platforms that have built-in ATR calculations system.
How to Use Average True Range for Stop Loss?
You can use the ATR to trade with stop-loss orders for the underlying security that has natural fluctuation in price movement. A simple rule of setting the stop loss using the ATR is to multiply the ATR by two to determine a reasonable stop-loss point.
Also Read: How to Set Target Price and Stop Loss in Intraday Trading
If you are going to take long position in a stock, you can place the stop loss at the level twice the ATR below the entry point and vice versa in case of short selling. Let’s make a predefined formula for stop loss calculation-
- SL for buying the Stock: Stop Loss = Entry Price - (ATR * Multiplier)
- SL for selling the Stock: Stop Loss = Entry Price + (ATR * Multiplier)
Additionally, you can exit from your trade positions when ATR is trading in the following stop line.
- Close your buy positions if ATR stop line triggered below
- Close your short positions if ATR stop line triggered above
How to Use Average True Range for Short-Term Trading?
As discussed above ATR is very usefull in all market conditions coupled with other technical in dicators. Apart from using the entry and exit points, you can use the ATR for various short-term trading strategies. Let’s find out how you can use the ATR for the short term with suitable trading strategies.
Also Read: How to Decide Best Entry & Exit Points in Intraday Trading
ATR Trading Strategy:
Identify the Entry & Exit Points
When ATR value is high, it gives the signal of potential opportunity as the volatility in the market is high and there could be volatile breakouts or breakdowns. On the other hand, when ATR is low, it suggests the market is likely to consolidate where the trend continuation or reversal is impending. However, combining top best technical indicators to know the precise exit and entry points for short-term trading is important to get better outputs from trading.
Also Read: What are the Best and most Accurate Trend Reversal Indicators
Use for Setting the Stop-loss
One of the best ways of using the ATR in trading is to set the stop loss at the right levels to minimize the risk if the market moves against your expectations. The value of ATR will help you to determine the stop loss below the entry point in long trade positions. While in short selling, the ATR will indicate the right stop loss above the entry point making it easier to exit.
For Position Sizing
Position sizing is one of the best trading strategies to help you minimize your risk tolerance. In short-term trading, you have enough time and opportunity to adjust your trade positions as per the changing market conditions.
Also Read: How to Manage or Do Risk Management in Options Trading
When the market is highly volatile or you can say, when ATR is high you can consider trading with smaller positions to limit your risk exposure. On the other hand, in low market volatility or when ATR you can take risks with large trade positions.
Use as an Indicator
The ATR is usually used to measure volatility levels, but in a trending market, it would be difficult to find the entry and exit points. Here you can use additional indicators like moving averages on the ATR that will work for you as signal lines giving the right indication.
Also Read: How to Find Trending Stocks for Intraday Trading: Ten Rules
You can use the 20-day simple moving average over the ATR and keep watching for the crossover. When ATR crosses above the signal line, you can consider it a bullish trend and go for long trade positions. While ATR crosses below the signal line gives the indication of a bearish trend providing you short-selling opportunity in the market or in the underlying security.
Also Read: Best Option Strategy for Bearish Market: 7 Option Strategies
For Breakouts
You can also use the ATR with a breakout or breakdown strategy in short-term trading. While considering the ATR showing the low value and the price of an underlying security breaks out from the low volatility levels, you can consider, that there is the possibility of sharp movement in the price. After the consolidation, the breakout or breakdown is possible if the volatility is high.
Also Read: How to Identify Trend in Stock Market: 10 Points to Find Trend
As a short-term trading opportunity, you can use the ATR to identify the breakouts with the opportunity to join the new trend at the initial stage of starting. After the sideways movement, the high ATR value suggests the high volatility in the market and you can plan how to trade when the breakouts occur in the market.
For Momentum Trading
The average true range indicator can be also used for momentum-based trading to enter into the trade with the perspective of short-term trading. The ATR value usually moves, when the price of the underlying security is likely to move faster than earlier which also leads to momentum in the price. Though, the momentum could be bullish or bearish, depending on the market sentiments.
Also Read: How to Identify Momentum Stocks for Intraday Trading: 8 Tips
Range Trading Strategy
If you are planning to trade with a range trading strategy, you can use the ATR to enter into such trading strategies. As the range, trading is highly dependent on the particular range in which you can use the ATR to measure the market volatility. And based on the ATR value you can come to know the range of trading in which you trade either long or short selling positions.
Some of the Limitations of ATR
Every technical indicator in trading has pros and cons, ATR is one of them but it has some limitations that make this indicator less preferred among the few traders. ATR is also considered as the lagging indicator that reacts to the historical price movement. Though, you can give an indication of current price movement but would be not useful for forecasting future volatility.
Also Read: Best Technical Indicators for Option Trading in TradingView
One of the other disadvantages of ATR is, that it can give an indication of the magnitude of price movement, not the trend or direction of the underlying security moving towards. Hence, to know the uptrend or downtrend you have to use other technical indicators too.
Also Read: What are the Top Best & Most Used Indicators in TradingView
Wrapping-up
The Average True Range can provide you with a powerful insight into know overall volatility level in the market. You can calculate the ATR using 14-day trading period using the other values in the ATR formula giving you the results that can be used in trading strategies. You can use the ATR to determine the stop-loss points or for short-term trading strategies.
In short-term trading strategies, ATR can be used to identify the entry or exit points, set the stop loss or position sizing and identify the breakouts or breakdowns.You can also use the ATR for momentum trading, and using it in coordination with other technical indicators like MACD, stochastic indicators, Parabolic SAR, and Bollinger Bands would be more effective.
Also Read: How to Reduce Slippage in Algo Trading: Tips to Avoid Slippage
To make the best use of such technical indicators, you have to choose the best trading platform that can provide you with all the trading facilities. Moneysukh offers one of the best online trading apps with the advantages of Algo trading in the same trading platform. You have to open a demat account and enjoy the lowest brokerage charges in all segments of trading.
Also Read: What Time Frame is Best for Intraday, Option & Swing Trading
