Average True Range Table of Contents
• Average True Range: Explain it Like I’m 5
• What is Average True Range?
• What’s the Best Time Frame for ATR?
• How to Calculate Average True Range
• How to Trade Using Average True Range
Average True Range: Explain it Like I’m 5
When you use your phone, you rely on the battery meter to show you how long you can use it before you need to recharge.
When you drive a car, you use the fuel gauge to determine how far you can travel before you have to stop and refuel. Imagine driving your car without a fuel gauge — you’d just be guessing at how far you could go!
Average true range (or ATR) is just like the battery meter on your phone, or the fuel gauge in your car. Simply put: ATR helps you determine whether a stock’s momentum-driven movement has more miles in the tank, or is running out of gas.
What is Average True Range?
Average True Range is a momentum trading indicator originally developed by market technician J. Welles Wilder Jr. in 1978. Back then, the ATR was a method used to measure volatility through a number of periods, designed for use in high volatility commodity markets.
For instance, when Ryan identifies a technical breakout in TNT Options or The Rebel Pit, he relies on a combination of technical levels and ATR to determine whether it’s worth chasing the price move, what time frame to use, and where to exit.
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What’s the Best Time Frame for ATR?
The average true range of a stock can be determined using any time frame, but the most common span is 14 days.
One negative to using shorter time frame ATR’s is that their results can create a lot of “noise” — erroneous conclusions drawn from small data sets. For example, if the ATR is only using five days worth of data, one macro event could create an outlier that skews the end result.
However, one positive to using shorter time frame ATR’s is that they can be more effective at reflecting near term market trends, and thus are still powerful tools for short-term trading.
As a rule of thumb, traders should use ATR time frames that reflect the intended time horizon of their trade.
How To Calculate Average True Range
While some brokerages (like ThinkOrSwim and Interactive Brokers) have tools for easily calculating a stock’s ATR, the calculation isn’t actually all that complicated. Understanding how the equation looks can help you to understand how and why average true range is such an effective indicator.
To calculate the ATR, you must take these steps:
- In reverse chronological order, starting with the first day in your ATR time frame, calculate the absolute value (absolute value is always a positive number) of the daily high, subtracted by the daily low.
- Calculate the absolute value of the daily high subtracted from the previous day’s closing value.
- Calculate the absolute value of the daily low subtracted from the previous day’s closing value.
- Calculate the mean average of these three values by adding them together and dividing the sum by three.
- Repeat steps 1 through 4 for each of the trading days within your preferred ATR time horizon.
- Average all of the values from step 5 together, and now you have calculated the average true range over the given time period.
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Trading with Average True Range
Imagine a stock has found support at the $100 level time and time again. But today, a particularly bearish event sends the stock plummeting, cutting decisively through the $100 level. The trend has been violated, and you’re thinking about making a short term bearish trade.
The first step would be to check the average true range. Like we said above, you want to use the ATR to identify how much gas is left in the tank. Has today’s bearish move exhausted the entirety of the average true range for the stock? Or is there still more momentum to go?
If there’s still plenty of ATR remaining, you might want to start pre-planning your trade, including thinking about your potential exit and time horizon.
Take a close look at the chart — where is the next area of support? Is there a nearby flat line that has previously served as support? Is there a nearby moving average or trend line that may threaten to put an end to the bearish momentum? Or is there enough room to the downside for you to get in — and out — before the ATR runs out?
If there’s plenty of room before the next area of support, and the stock’s average true range is greater than today’s move, then you can pat yourself on the back for two reasons:
- You’ve just done more research and planning than 90% of day traders.
- You’ve got a solid candidate for a short-term momentum trade.
The Bottom Line: You’re now armed with a powerful momentum trading tool used by some of the top technical traders. Start using average true range to inform your entries and exits, and you’ll be scalping with the best of them in no time.