When performing a technical analysis we must take into account a series of indicators, and formulas to know trends and prices in our possible investments, and thus make the best decision. One such indicator is the ATR (Average True Range).
What are technical indicators?
Technical Indicators are mathematical and statistical formulas that are applied to price and volume series, with the intention of helping to make investment decisions or to locate prices in certain phases or situations. The indicators show us if the price is in a certain trend, in an overbought, oversold phase or if it diverges from the price, being able to indicate changes in the trend of prices.
Among the most used technical indicators, we find:
|Trend Following Indicators
|Advance decline line
|Money Flow Index (MFI)
|Chaikin Money Flow
|Rate of change
|ATR Average True Range
How can I use technical indicators?
Indicators can provide us with guidelines to define entry and exit points of operation, and should be seen by all system traders as a way to help increase profitability. The goal of this post is to provide you with an introduction to the ATR (Average True Range) indicator and how to apply it to our stock and index analysis.
To learn how to implement its use, we will use the Clicktrade platform as one of the most used for stock trading and for the high functionality it allows in the implementation of these indicators.
What is ATR?
The ATR (Average True Range or True Average Range), is a measure of volatility created by J. Welles Wilder Jr, in his book New Concepts in Technical Trading Systems, in 1978. As a curiosity its creator, is also the creator of such famous technical indicators as the Relative Strength Index (RSI), Average Directional Index, and the Parabolic SAR.
The range of a stock is the difference between the high and low price on any given day. It reveals information about how volatile an asset is. Large ranges indicate high volatility and small ranges indicate low volatility.
This indicator is applied in the same way to options and futures of commodities, as it is to stocks.
How Did the ATR Come About?
At the time this indicator was designed, one of the main differences between stocks and commodity markets was that in the main futures exchanges, attempts were made to avoid extremely erratic price movements, by putting a cap on the amount that a market can move in a single day.
This is known as the lock limit and represents the maximum change in the price of a product for one day. During the 1970s, when inflation reached unprecedented levels, cereals and other commodities often experienced limit movements. In those days, a bullish market opened at the limit and no more trading took place. The range proved to be an inadequate measure of volatility given the limit movements; while the daily range indicated that volatility was low, the reality was that markets were more volatile than they had ever been.
Wilder was a futures trader at the time, which made it difficult for him to implement some of the systems he was developing. His idea was that high volatility would follow periods of low volatility. This would form the basis of his intraday trading system.
How Is ATR Calculated?
To calculate the ATR we must start from the calculation of the True Range, which was developed by Wilders to address the previous problem by accounting for the gap and more accurately measure daily volatility, what was possible through the simple calculation of the range.
The True Range is the highest value of the result of the following 3 equations
- TR= High – Low
- TR= High – Previous day close
- TR= Previous day close- Low
- TR: is the True Range
- High: represents the maximum of the day
- Low: represents the minimum of the day
The average true range (ATR) is an exponential moving average of the true range. Wilder used an ATR of 14 days to explain the concept. Traders can use shorter or longer periods according to their preferences when trading. Longer periods will be slower and will likely lead to fewer trading signals, while shorter periods will increase the volume of trades.
In most trading platforms we can find this indicator, in particular in the Clicktrade we can add it by following the following steps:
- We choose the asset to which we want to add: in our example, we will use the ABERTIS share and we will deploy the full-screen view. Once here we open the add indicator menu and select the Average True Range (ATR).
2. Once the indicator is added, the configuration options will appear. By default, an ATR of 10 sessions is displayed, which we can modify using the 14 or 20 sessions that are most common.
3. If we want to apply any strategy with more indicators, we would simply have to go back to the add indicator menu and incorporate it. In the example images I have added the Bollinger Bands and moving averages
How to Interpret the ATR?
The ATR does not necessarily indicate the exact moment of a trend change, although it can warn of the impulse of a trend. To effectively identify entry and exit points or directions, other indicators such as the relative strength index and the moving average convergence divergence should be considered.
Its interpretation would be as follows:
- High values of the ATR indicate high activity in the market and, therefore, that the movements that occur will be of a wide range. Very high values are produced as a result of a large increase or decrease and it is very unlikely that the ATR will remain at high values for a long time.
- Low values of the ATR indicate little activity, a quiet market in which the movements will be short.
- Low values of the ATR for a long time indicate price consolidation and can be the starting point or continuation of a trend.
Most frequent strategies using ATR
1) With momentum strategies
- If a stock is in an uptrend and the ATR starts to rise, it means that price fluctuations are increasing, which may indicate a reversal.
2) With supports and resistance
- The ATR can also be used to confirm a trend. If a lower support line is broken, indicating a downtrend, a trader can confirm the strength of the bearish sentiment if the ATR has increased.
3) With Bollinger Bands
- Another example of an application would be its combination with Bollinger Bands. If the ATR increases at the time when prices are above the upper band, it indicates an upcoming trend change.
4) ATR Multiples
- Many traders create their systems from the use of ATR or a multiple of ATR. This system consists of adding that value to the quotation of the next day and it is bought when the prices move above that level.
- For example, if the XYZ stock has an ATR of 17 and a current price of 30.50€, a trader can assume an oscillation of the price of 17 points in the current pattern of the trend. If that pattern is currently bullish, the trader can assume that the stock price can reach a maximum of 30.67€ and operate accordingly.
5) With moving averages
- One of the most used systems with moving averages is the ATR channel break. For its implementation, a long-term moving average is used, for example, MM of 70 weeks.
- We add the volatility channel from the MM70. To do this, the upper limit of said channel is plotted by adding 2·ATR to the value of the MM70 and the lower limit by subtracting 2·ATR from the MM70. As we see, in the end, we will have a volatility channel with a total size of 4·ATR.
- Variations of this size can be used, although it is recommended that it always remain in the range between 3·ATR and 5·ATR.
6) To define Stop loss
To place the stop loss point you simply calculate the distance between your entry +/- the value of the ATR at that time. If we want to place a stop-loss based on the ATR, we will place it at factor*ATR.
And How Much Will the Factor Be?
It depends on the system, the market, and the time frame in which we work. It is reasonable to place the stop-loss > 1 ATR, 2 ATR could be a suitable place to place a stop-loss. We would be putting it at double the average volatility of the market.
ATR is a versatile tool that helps traders measure volatility and can help us make better entry and exit decisions. A complete trading system can be implemented using only this indicator.
How can I use the ATR to set stop-losses and profit targets?
he ATR can be used to set stop-losses and profit targets by multiplying the ATR by a factor. For example, if you want to set a stop-loss at 1 ATR, you would multiply the ATR by 1. If you want to set a profit target at 2 ATR, you would multiply the ATR by 2.
How can I use the ATR to trade breakouts?
The ATR can be used to trade breakouts by waiting for the price to break above or below the ATR. Once the price breaks above or below the ATR, you can enter a trade in the direction of the breakout.
How does the ATR differ from other volatility indicators?
The ATR is different from other volatility indicators in that it takes into account the gap between the high and low prices of the day, as well as the difference between the high price of the day and the previous day's close, and the difference between the low price of the day and the previous day's close.