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| Image: Moneybestpal.com |
Average True Range (ATR) is a technical indicator that measures the volatility of an asset's price over a given period of time. It is calculated by taking the average of the true ranges of each period, which are the greatest of the following:
- The current high minus the current low
- The absolute value of the current high minus the previous close
- The absolute value of the current low minus the previous close
Any gaps that might exist between periods are also included in the true range, which depicts the full extent of price fluctuation. Following that, the ATR is a moving average of the true ranges, often based on 14 periods. Whether it be for stocks, commodities, FX, or futures, the ATR may be used to analyze any kind of price data.
To evaluate market conditions and locate prospective trading opportunities, one can use the ATR. The asset is experiencing significant volatility, which means that the price is changing quickly and erratically, according to a high ATR. The price is moving within a constrained and stable range when the ATR is low, which signifies the asset is experiencing low volatility.
Finding the ideal position size and risk-reward ratio for a trade is one approach to using the ATR. One can set a stop-loss level that is proportional to the asset's volatility by multiplying the ATR by a number, say two or three. For instance, if the ATR is $1 and a 2x ATR stop-loss is used, the stop-loss level for a long trade would be $2 below the entry price, and for a short trade, it would be $2 above the entry price. By doing so, one can stay out of the path of erratic price changes and only get out of a trade when the trend has significantly changed.
The ATR can also be used to spot breakouts and trend reversals. A breakout happens when the price moves past a particular level of support or resistance, signaling a change in the trend's direction. After a prolonged advance up or down, the price shifts direction, signaling a trend reversal. One can define a threshold that alerts traders to a breakout or reversal when the price crosses it by multiplying the ATR by a certain number, say four or five times. A breakout or reversal would be confirmed if the price moved $4 above or below a prior high or low, for instance, if the ATR is $1 and one applies a 4x ATR threshold.
The following chart provides an illustration of how to utilize the ATR to determine stop-loss levels, spot breakouts, and spot price reversals for Apple stock (AAPL). The 14-period ATR, which lies between $20 and $60, is represented by the blue line. The stop-loss levels for long trades represented by the red dots are set $4 below the entry prices and are based on a 2x ATR. The 4x ATR breakout and reversal thresholds are represented by the green dots and are set $8 above or below prior highs or lows.
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| Image: TradingView |
The chart illustrates how employing the ATR can assist traders in capturing significant market fluctuations while preventing false signals and whipsaws. For instance, in late January 2020, AAPL exceeded the 4x ATR level of $82 and broke out above its prior high of $67, suggesting a strong bullish trend. When AAPL reversed its trend and crossed below its previous low of $76 and its 4x ATR threshold of $75, signaling a strong bearish trend, traders may have launched a long trade by employing a 2x ATR stop-loss of $75 and held it until late February 2020. A 2x ATR stop-loss of $76 would have allowed traders to exit their long position with a profit of around $46 per share.
