The indicator known as average true range ATR can be used to develop a complete trading system or be used for entry or exit signals as part of a strategy. Professionals have used this volatility indicator for decades to improve their trading results. Find out how to use it and why you should give it a try.
The average true range is a volatility indicator. Volatility measures the strength of the price action , and is often overlooked for clues on market direction. We can see the lines start out fairly far apart on the left side of the graph and converge as they approach the middle of the chart.
After nearly touching each other, they separate again, showing a period of high volatility followed by a period of low volatility. Knowing that a stock is likely to experience increased volatility after moving within a narrow range makes that stock worth putting on a trading watch list. When the breakout occurs, the stock is likely to experience a sharp move. For example, when Hansen Nasdaq: HANS broke out of that low volatility range in the middle of the chart shown above , it nearly doubled in price over the next four months.
The ATR is another way of looking at volatility. Periods of low volatility, defined by low values of the ATR, are followed by large price moves. 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.
This idea is shown in Figure 3. Trading signals occur relatively infrequently, but usually spot significant breakout points. The logic behind these signals is that whenever price closes more than an ATR above the most recent close, a change in volatility has occurred.
Taking a long position is a bet that the stock will follow through in the upward direction. The same logic applies to this rule - whenever price closes more than one ATR below the most recent close, a significant change in the nature of the market has occurred. Closing a long position becomes a safe bet, because the stock is likely to enter a trading range or reverse direction at this point.
For related reading, see Retracement Or Reversal: The use of the ATR is most commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the "c handelier exit" and was developed by Chuck LeBeau. The chandelier exit places a trailing stop under the highest high that the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR.
For example, we can subtract three times the value of the ATR from the highest high since we entered the trade. For related reading, see Trailing-Stop Techniques. The value of this trailing stop is that it rapidly moves upward in response to the market action. LeBeau chose the chandelier name because "just as a chandelier hangs down from the ceiling of a room, the chandelier exit hangs down from the high point or the ceiling of our trade. The ATR Advantage ATRs are, in some ways, superior to using a fixed percentage because they change based on the characteristics of the stock being traded, recognizing the fact that volatility varies across issues and market conditions.
As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader's desire to protect profits with the necessity of allowing the stock to move within its normal range. ATR breakout systems can be used by strategies of any time frame. They are especially useful as day trading strategies.
Using a minute time frame, day traders add and subtract the ATR from the closing price of the first minute bar. This provides entry points for the day, with stops being placed to close the trade with a loss if prices return to the close of that first bar of the day.
Any time frame, such as five minutes or 10 minutes, can be used. This technique may use a period ATR, for example, which includes data from the previous day.
Another variation is to use a multiple of ATRs, which can vary from a fractional amount, such as one-half, to as many as three beyond that there are too few trades to make the system profitable. Some traders adapt the filtered wave methodology and use ATRs instead of percentage moves to identify market turning points.
Under this approach, when prices move three ATRs from the lowest close, a new up wave starts. A new down wave begins whenever price moves three ATRs below the highest close since the beginning of the up wave.
Conclusion The possibilities for this versatile tool are limitless, as are the profit opportunities for the creative trader. It is also a useful indicator for the long-term investors to monitor because they should expect times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods of time.
They would then be ready for what could be a turbulent market ride, helping them avoid panicking in declines or getting carried way with irrational exuberance if the market breaks higher. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
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