Trading Up-Close: Average True Range

Average True Range, or ATR, is a technical indicator that can tell you how volatile a stock has been, on average, over a specified period. ATR is particularly useful for setting exit levels as part of your risk-management strategy. It can also give you a sense of how strong price moves are, which is helpful if you’re trying to identify the start of a trend.

In short, ATR takes a holistic look at a stock’s price moves over a set period and smooths them out in a single number, expressed as a dollar amount.

ATR is based on the concept of true range, which is basically a way of measuring a stock’s daily trading range that accounts for gap openings, i.e., when a stock opens sharply higher or lower relative to the previous day’s closing price.

Why is it important to account for gaps? Here’s an example.

Imagine two stocks that both close at $50 a share. Overnight, stock A gaps higher and opens at $60, while stock B opens close to its $50 close the day before. Stock A then goes on to trade within a range of $3 between its daily high and low, while stock B trades within a wider range of $5.

Traders who look only at a stock’s daily trading range might say stock B is more volatile because it experienced wider price swings that day. But that fails to take account of stock A’s $10 gap up overnight.

True range allows for gap openings like this by comparing the day’s highs and lows with the previous day’s levels, giving you a better sense of how much the stock’s price has actually moved over time.

Averaging out a stock’s daily true range values over a defined period gives you its ATR. The default period on many trading platforms is 14 days. Some traders also use 20 or 22 days, as there are generally between 20 and 22 trading days in a month.       

Before getting into how to use ATR, there are a few things to note. First is that ATR is based on absolute price changes, not percentage changes. Accordingly, higher priced stocks typically have higher ATR values than lower priced stocks. After all, a $10 move in a $100 stock is less significant than a $10 move in a $20 stock.

Second, changing ATR values indicate changes in volatility. If a stock’s ATR is rising, it means volatility has increased over the period, either because of a sharp rise or a sharp fall—ATR doesn’t tell you which direction a stock has been moving, just that it has been moving. If the ATR is shrinking, it means the stock has been trading sideways over the period.

So how do traders use Average True Range?

Some traders use ATR to help them set stop loss levels. Say a trader sees a stock trading near a support level and the stock has a 20-sday ATR of $2.25. He or she might place a stop loss order at a bit more than $2.25 below support, so that a one-day move through that support might not trigger the order. Remember, too, that there’s no guarantee an order will be executed at or near your stop price.

Traders can also use a strategy called a Chandelier Exit, which uses ATR to set trailing stops and is designed to help traders ride a trend while managing the risk of an early exit in the event of a temporary reversal. A common approach is to set a trailing stop three 22-day ATRs below each new high in an up-trending stock, or over each new low in a down trending one. With a trailing stop, the stop price can tick up or down to account for changes in the stock’s price. Then, if the stock changes direction, the stop price will freeze at its new level—and if the stock then hits the new stop price, it becomes a market order.

So, if a stock has a 22-day ATR of $2, then you would set your trailing stop $6 above or below the current market price. The idea is to have a buffer that is three times the current volatility of the stock. As a result, when volatility as measured by ATR is high, you have a larger buffer, which can give a stock more room to swing, so be sure you’re comfortable with that. When it is low, your buffer is smaller. Of course, whether three 22-day ATRs works for you will depend on your risk tolerance. 

If you’re trading an uptrend, you might consider selling a long position if the stock’s price falls below your Chandelier Exit. Similarly, if you’re trading a downtrend, you might consider selling a short position if the stock rises above your exit.

Finally, traders also use ATR to gauge the enthusiasm behind a stock move. Strong moves either up or down are often accompanied by expanding ATR values. This is especially true at the beginning of a trend. For example, a break of support or resistance with an increase in ATR tends to validate the move.

To learn more about technical indicators and how to use them, watch the other videos in this series and subscribe to our YouTube channel.