ATR Indicator and Strategies

In this article, we will discuss

• What is the Average True Range (ATR)?
• How is the Average True Range (ATR) Calculated?
• How to Interpret the Average True Range Indicator?
• Commonly Used ATR Trading Strategies
• Conclusion

One of the many tools that you can use to gain an edge while trading is technical indicators. Technical indicators can provide valuable insights into market sentiment, volatility, and even potential price movements.

On the Samco Trading App, you can get access to advanced technical indicators, such as the ATR indicator, at your fingertips. Additionally, you also get real-time market data, customisable charts, and the ability to execute trades swiftly, all from the convenience of your smartphone or a computer.

Now, among the plethora of technical indicators that traders use, the ATR indicator often stands out as a powerful and versatile option. In this comprehensive guide, we will delve into this particular indicator and explore its calculation and interpretation. Additionally, we will also look at a few of the most popular ATR trading strategies that you can consider using.

What is the Average True Range (ATR)?

Developed by J. Welles Wilder Jr. and introduced in 1978, the average true range (ATR) is a technical indicator used to measure the volatility in the market. The indicator provides a quantitative measure of the degree of price movement or variability over the chosen time frame. This is highly unlike many other technical indicators, which focus primarily on the price direction.

One of the key strengths of the ATR is its adaptability. It can be applied to any asset, ranging from stocks to currencies or commodities. Additionally, the indicator can also be used across any timeframe, from intraday charts to weekly or monthly analysis. This versatility makes it a valuable tool for a wide range of trading styles and strategies.

How is the Average True Range (ATR) Calculated?

Understanding the calculation of the ATR can help you better interpret and apply it in your trading decisions. Here is a step-by-step process of how you can calculate the average true range.

• Step 1: Calculating the True Range (TR)

The first step is to determine the true range (TR) of the asset. It is the greatest of the following three values:

• The difference between the current high and the current low.
• The difference between the current high and the previous close.
• The difference between the current low and the previous close.

The logic behind ascertaining the true range is that doing so ensures that the gaps between trading periods are accounted for, providing a more accurate measure of volatility.

• Step 2: Creating an Initial ATR Value

To start the ATR calculation, an initial value is needed. This is done by determining the simple moving average (SMA) of the true range over a certain number of periods. Typically, the most common period that traders choose is 14 days. However, it can be adjusted based on your preference.

Mathematically, the initial ATR indicator formula can be represented as follows:

Initial ATR = SMA of TR over a 14-day period

• Step 3: Calculating Subsequent ATR Values

After the initial ATR is established, subsequent values are calculated using a modified moving average formula. This ensures that more weight is given to recent data while still considering historical volatility.

The ATR indicator formula for calculating subsequent ATR values is as follows:

Current ATR = {[Previous ATR x (14 - 1)] + Current TR} ÷ 14

Here, the previous ATR represents the ATR value from the previous period, whereas the current TR represents the true range for the current period.

This calculation is repeated for each new period, creating a smoothed line that represents the average volatility over the specified timeframe.

How to Interpret the Average True Range Indicator?

Interpreting the ATR indicator is crucial for leveraging its insights effectively in your trading strategies. While the indicator does not indicate price direction, it provides valuable information about market volatility, which can be useful for various aspects of your trading decisions.

The ATR is typically displayed as a single line on a chart and is often plotted below the main price chart. Its value is expressed in the same units as the price of the asset being analysed. The higher the ATR value, the higher the volatility in the asset is supposed to be. For instance, an asset with an ATR value of 3 will be significantly more volatile compared to the same asset with an ATR value of 0.5.

Additionally, while absolute ATR values can be helpful, tracking the relative changes in the average true range can also provide crucial insights. For example, if the ATR is rising, it indicates increasing volatility, which could signal the start of a new trend or a potential reversal. Meanwhile, a falling ATR suggests decreasing volatility, which is often associated with periods of consolidation and weakening of a trend.

Commonly Used ATR Trading Strategies

The average true range indicator is a versatile tool that can be incorporated into various trading strategies. Here are some commonly used ATR-based strategies that traders employ across different markets:

• Volatility Stop Loss Strategy

A highly useful ATR trading strategy that focuses on risk management, the volatility stop loss strategy uses the average true range of an asset to set the ideal stop loss point. It involves setting the stop loss as a multiple of the ATR below the entry point for long positions and above the entry point for short positions. Here is an example to help you understand how this strategy works.

Assume you wish to purchase a stock. The current price of the stock is Rs. 100, and the current ATR is Rs. 5. You could set the stop-loss at 2 times the ATR, which is Rs. 10 (Rs. 5 x 2) below from the entry point since this is a long position. This means if the stock drops to Rs. 90, the position will be automatically sold, limiting potential losses in volatile markets.

• Breakout Strategy

This particular ATR trading strategy can help you uncover potential breakout points. To use this strategy, you must first identify a range-bound market. Then, calculate the ATR and multiply it by a factor, such as 1.5 or 2. If the price breaks above the range by the multiple of the ATR, consider entering into a long position. Meanwhile, if the price breaks below the range by the multiple of the ATR, you may enter into a short position.

For example, assume a stock is trading between a range of Rs. 400 and Rs. 500 and the current ATR is Rs. 30. Multiplying the ATR by a factor of 1.5, we get Rs. 45 (Rs. 30 x 1.5). Now, if the price of the stock reaches Rs. 545 (Rs. 500 + Rs. 45), a breakout is said to be in effect. At this point, you can enter into a long position to cash in on the subsequent price movements. Similarly, if the price of the stock falls to Rs. 355 or lower (Rs. 400 - Rs. 45), you may choose to enter into a short position.

• Trailing Stop Strategy

Another ATR trading strategy focusing on risk management, the trailing stop strategy is similar to the volatility stop-loss strategy but is used to lock in profits. As the price moves favourably, the trailing stop is adjusted to a certain number of ATRs away from the high point of the price. Here is an example of how you can use this strategy to your advantage.

Assume you enter into a long position on a stock at Rs. 500 per share and the current ATR is Rs. 10. You decide to set a trailing stop at twice the current ATR value, which comes to Rs. 20 (Rs. 10 x 2), below the current share price. If the stock price rises to Rs. 550 per share, the trailing stop would move up to Rs. 530 (Rs. 550 - Rs. 20). This allows you to secure some profit while still allowing room for normal price fluctuations.

• Divergence Strategy

The divergence strategy is a unique ATR trading strategy that looks for divergences between the average true range and the price action. A divergence is said to occur when the price reaches new highs or lows, but the ATR does not confirm these highs or lows. Such divergences usually indicate a possible reversal, which you can leverage.

For instance, if a stock's price hits a new high but the ATR is declining, it could potentially indicate that the new high is not supported by increased volatility and that it could be unsustainable. You can view this as a signal to prepare for a potential reversal and may consider taking profits or setting up a short position.

• Position Sizing Strategy

This ATR trading strategy uses the average true range to determine the size of the position to take in a trade based on the current volatility of the market. The logic behind this strategy is to adjust the size of the position inversely with volatility. This essentially means that if the volatility is high, the position size you must take must be small, and vice versa.

Imagine you have a total risk tolerance level of Rs. 20,000 per trade, and the ATR for a particular stock is currently Rs. 500. You decide to risk 1 ATR per trade. Now, the maximum number of shares you can buy or sell must be limited to 40 (Rs. 20,000 ÷ Rs. 500). This ensures that the position size is adjusted according to the market's volatility, keeping the risk consistent across different market conditions.

Conclusion

As you can see, the ATR indicator is a highly versatile tool that can help you plan your trades more efficiently. The indicator’s ability to quantify market volatility provides invaluable insights that can enhance entry and exit timing, position sizing and risk management.

However, as with any trading tool or strategy, using it solely to make trading decisions can lead to suboptimal outcomes. Remember to always pair the ATR indicator with other technical analysis tools and candlestick chart patterns for more accurate trading signals.

With the Samco Trading App, you can get access to not just the average true range but also a plethora of other technical indicators, including a comprehensive charting tool in the form of TradingView charts.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING. The asset classes and securities quoted in the film are exemplary and are not recommendatory. SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008 CIN No.: U67120MH2004PLC146183 | SAMCO Commodities Limited (Formerly known as Samruddhi Tradecom India Limited) | MCX- 55190 | SEBI Reg. No.: INZ000013932 Registered Address: Samco Securities Limited, 1004 - A, 10th Floor, Naman Midtown - A Wing, Senapati Bapat Marg, Prabhadevi, Mumbai - 400 013, Maharashtra, India. For any complaints Email - grievances@samco.in Research Analysts -SEBI Reg.No.-INHO0O0005847