When & How Average True Range Can Boost Your Trading Odds

Believe it or not, the average true range (ATR) can be a highly effective volatility indicator to use with your trading — both professionally and at home! While it might seem simple, the ATR is a stepping-stone to understanding your stocks volatility and making the best decisions from there. 

ATR

The average true range shows how much an asset moves throughout a set time period. As the price for an asset increases or decreases, the ATR moves up or down on the chart. As your selected time period passes, a new mark for your assets' average is added to the chart to analyze the security's volatility over time. In short, it gives traders a sense of how much a security can be expected to move.

To calculate the Average True Range, you require multiple samples of the True Range which is the measuring stick for a single day.  True range uses three separate calculations and the largest measurement in absolute value terms (no negative numbers) of the three is utilized.

They record the value for each time period and then take the moving average as the indicator of volatility. This is generally 14 days, although, with the StockOdds system, you can select the time period you'd like to look at, from 5 days, 10 days, 14 days, 20 days, 50 days and 200 days. Once again, for the above calculation, it doesn't matter if the number is positive or negative; it just has to be the greatest absolute number.  

It may look like a larger ATR indicates more volatility, while a lower ATR less so, but it is also a function of price.  If you have a $100 stock with an ATR of $1.00, and a $50 stock with an ATR of $1.00, while their ATR’s are the same, the $50 stock is actually twice as volatile.

Note: If a trader opts for a shorter period, they'll receive more trading signals. Fourteen days or longer will generate smoother data with fewer signals. 

How To Use It

This tool is excellent to add to an already established trading system. Thanks to StockOdds' extensive database, it is an easy indicator to add, as the premise of the ATR is all based on historical data! This is especially useful when it comes to triple-checking your Odds. While the volatility may be higher or lower for your selected time period, it may not be that strange given the security's history. Remember as well; the indicator only shows volatility and not direction. Comparing ATR readings to previous data is crucial for successful implementation.

But how and why do traders actually use the ATR? To know when to exit and enter trades, including with stop-loss orders (for more on order types, check out this blog post). A bonus of the ATR is that it can help with exit decisions, no matter how the entry decision was made. Here’s an example from Investopedia for how to use the ATR to create IF-THEN parameters for the next day: 

“Assume the first value of the five-day ATR is calculated at 1.41 and the sixth day has a true range of 1.09. The sequential ATR value could be estimated by multiplying the previous value of the ATR by the number of days less one, and then adding the true range for the current period to the product.

Next, divide the sum by the selected timeframe. For example, the second value of the ATR is estimated to be 1.35, or (1.41 * (5 - 1) + (1.09)) / 5. The formula could then be repeated over the entire time period.

While the ATR doesn't tell us in which direction the breakout will occur, it can be added to the closing price, and the trader can buy whenever the next day's price trades above that value.”

You can also create stop-loss points by multiplying your ATR by a number to identify a reasonable stop point. Balance suggests multiplying it by two “as a general rule of thumb.” By multiplying by two, you can strategically add a stop loss at two times below the ATR price for buying or at two times above the ATR price for shorting a stock. Here’s an example of how it works from Balance: 

“Suppose you take a long trade at $10, and the ATR is $0.10. You would place a stop-loss at $9.80 (2 * $0.10 below $10). The price rises to $10.20, and the ATR remains at $0.10. The trailing stop-loss is now moved up to $10. When the price moves up to $10.50, the stop-loss moves up to $10.30, locking in at least a 30-cent profit on the trade. This would continue until the price falls to hit the stop-loss point.”

So, while an ATR may seem like a simple number, it can be a powerful trading tool — especially when used correctly, partnered with other indicators (remember, it doesn't indicate direction) and backed up with statistical data from StockOdds. Are you using true ranges in your trading repertoire?