Average True Range (ATR)

In stock trading, we often want to know how much a stock's price moves over a certain period. One useful way to measure this movement is called the Average True Range, or ATR. It tells traders how much a stock usually moves in a day, giving insights into the stock's volatility, or how quickly and widely it swings in price.

What is Average True Range (ATR)?

The Average True Range is a measure of price movement over time. It was created by a famous trader named J. Welles Wilder Jr. to help traders see how much a stock's price moves up and down. It doesn't tell us if the stock will go up or down, but it does tell us how much it might move in either direction. If the ATR is high, it means the stock has been moving a lot. If it's low, it means the stock has been moving only a little.

Why ATR Matters for Traders

ATR is important because it helps traders understand how “risky” a stock is. A stock with a high ATR might be riskier because its price changes a lot. This can mean greater potential rewards, but also higher potential losses. A stock with a low ATR usually means smaller, steadier price changes, which may feel safer but might not give as big of returns.

• Volatility: ATR is a way to measure volatility, which is how much a stock's price changes over time.
• Risk Assessment: If the ATR is high, it's usually riskier. If it's low, it's less risky.
• Time Frame: ATR can be calculated for different time frames, such as daily, weekly, or monthly.

How to Calculate ATR

The first step in calculating ATR is to find something called the “True Range” (TR). The True Range is the largest of three numbers:

1. The current day's high minus the current day's low.
2. The absolute value of the current day's high minus the previous day's close.
3. The absolute value of the current day's low minus the previous day's close.

Once we have the True Range for each day over a certain period, usually 14 days, we calculate the average of these numbers. This average is the Average True Range.

Using ATR in a Simple Example

Imagine a stock called “XYZ” that has the following price movements over three days:

• Day 1: High of $20, Low of $15, Close of $18
• Day 2: High of $25, Low of $17, Close of $20
• Day 3: High of $27, Low of $19, Close of $24

To calculate ATR, we would find the True Range for each day, average them over a set period, like 14 days, and that would give us the ATR. A higher ATR might indicate that XYZ stock has been experiencing larger price swings, while a lower ATR would suggest smaller movements.

How Traders Use ATR

Traders use ATR in different ways, depending on their goals:

• Setting Stop-Loss Levels: A stop-loss is a pre-set price level where a trader decides to sell to avoid further loss. ATR can help traders set stop-loss levels to match the stock's volatility. For example, if the ATR is $2, a trader might place a stop-loss $2 below their entry price to allow for daily movement without getting stopped out too quickly.
• Identifying Breakouts: Breakouts occur when a stock's price moves out of a specific range. If the ATR suddenly rises, it could indicate a breakout, meaning the stock might start moving in a new direction.
• Determining Position Size: If a stock is highly volatile, a trader might buy fewer shares to manage risk. A lower ATR might allow for a larger position size since the stock has smaller swings.

Advanced ATR Applications

Experienced traders use ATR in more complex ways to tailor their strategies. For example, they might combine ATR with other indicators like the Relative Strength Index (RSI) or Moving Averages to get a fuller picture of a stock's potential price action. Here's how:

• Pairing ATR with RSI: RSI is a momentum indicator that shows whether a stock is overbought or oversold. A trader might look at both ATR and RSI together to identify high-volatility environments with potential trend reversals.
• ATR Trailing Stop: Advanced traders use ATR to set a trailing stop, which automatically adjusts as the stock moves. This can help lock in gains while allowing for price fluctuations.

Limitations of ATR

While ATR is a helpful tool, it's not perfect. ATR doesn't predict price direction—only the range of movement. It's also a backward-looking indicator, meaning it relies on past data and may not always represent future volatility. Additionally, ATR doesn't work as well with extremely low-volume stocks, as low trading volume can cause erratic ATR readings.

Conclusion: ATR as Part of a Trading Strategy

Average True Range (ATR) is a valuable tool for understanding stock volatility and managing risk. It can help traders of all levels make more informed decisions, from setting stop-losses to managing position size. As with any indicator, ATR is most effective when used alongside other tools and methods. Whether you're a beginner or an experienced trader, understanding ATR and how it relates to other indicators can enhance your overall trading strategy.