Enter Profitable Territory With Average True Range

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Enter Profitable Territory With Average True Range

The average true range (ATR) indicator may be used to create a comprehensive trading system or to provide entry and exit signals as part of a strategy. For decades, professionals have utilized this volatility indicator to enhance their trading performance. Learn how to use it and why you should try it.

What Is ATR?

The average true range measures volatility. Volatility gauges the strength of price activity and is sometimes neglected as a source of market direction. Bollinger Bands are a more well-known volatility indicator. John Bollinger argues in “Bollinger on Bollinger Bands” (2002) that “high volatility begets low volatility, and low volatility begets high.” The figure below focuses exclusively on volatility, leaving out price, allowing us to observe that volatility follows a distinct cycle.

Image by Sabrina Jiang © Investopedia2020

The degree of volatility in the price is shown by how close the upper and lower Bollinger Bands are at any particular period. The lines begin very widely apart on the left side of the graph and converge as they reach the center of the graph. They almost touch before separating again, indicating a time of extreme volatility followed by a period of moderate volatility.

Bollinger Bands are well-known and can predict a lot of what will happen in the future. Knowing that a stock is likely to suffer more volatility after moving inside a limited range is reason enough to add it to a trading watch list. When the breakout comes, the stock is expected to surge sharply. For example, when Hansen Natural Corporation (now Monster Beverage Corporation (MNST)) broke out of the low volatility region in the center of the chart (seen above), its price almost quadrupled over the following four months.

  Be Aware of the Hindenburg

Another approach to look at volatility is via the ATR. The same cyclical characteristic can be seen in ATR (seen in the bottom half of the chart) as in Bollinger Bands. Low volatility periods, as characterized by low ATR values, are followed by significant price changes.

Image by Sabrina Jiang © Investopedia2020

Understanding Trading With ATR

The issue for traders is determining how to benefit from the volatility cycle. While the ATR does not indicate which way the breakout will occur, it may be added to the closing price and used to purchase if the following day’s price trades above that number. This concept is shown below.

Trading signals occur seldom, but they generally coincide with important breakthrough moments. The reasoning behind these indications is that if the price closes more than an ATR above the most previous close, there has been a change in volatility. Taking a long position implies wagering that the stock will continue to rise.

Image by Sabrina Jiang © Investopedia2020

ATR Exit Sign

Traders may exit these trades by producing signals based on subtracting the ATR value from the closing. The same rationale applies to this rule: anytime the price closes more than one ATR below the most recent close, there has been a major change in the market’s character. Closing a long position becomes a safe decision at this time since the stock is likely to enter a trading range or reverse direction.

The ATR is most typically employed as an exit technique that may be utilized regardless of how the entrance choice is made. Chuck LeBeau invented one common method known as the chandelier escape. The chandelier exit establishes a trailing stop below the stock’s highest high since you started the transaction. The distance between the highest high and the stop level is determined by multiplying the ATR by a multiple. For instance, we may deduct three times the ATR value from the highest high since we started the trade.

  Multiple Time Frames Can Multiply Returns

The advantage of this trailing stop is that it swings quickly higher in reaction to market activity. “Just like a chandelier hangs down from the roof of a home, the chandelier exit hangs down from the high point or ceiling of our trade,” LeBeau said.

The ATR Advantage

ATRs are better than set percentages in certain aspects since they alter dependent on the features of the stock being traded, understanding that volatility differs across problems and market situations. The distance between the stop and the closing price automatically adjusts and moves to a suitable level when the trading range grows or reduces, combining the trader’s desire to safeguard gains with the requirement of allowing the stock to move within its regular range.

Strategies of any time range may leverage ATR breakout systems. They are particularly beneficial as day trading methods. Day traders use a 15-minute time period to add and subtract the ATR from the closing price of the first 15-minute bar. This gives entry opportunities for the day, with stops set to complete the trade at a loss if prices return to the closing of the day’s first bar. Any time limit, such as five or ten minutes, may be employed.

For example, a 10-period ATR that incorporates data from the prior day might be used in this strategy. Another option is to employ numerous ATRs, which may range from a fraction, such as half, to as many as three. (Aside from that, the system has too few trades to be lucrative.) Toby Crabel proved that this strategy works on a range of commodities and financial futures in his 1990 book, “Day Trading With Short-Term Price Patterns and Opening Range Breakout.”

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To detect market turning moments, some traders use the filtered wave approach and utilize ATRs instead of percentage changes. When prices move three ATRs away from the lowest closure, a new up wave begins. When price goes three ATRs below the highest closing since the commencement of the up wave, a new down wave starts.

The Bottom Line

The chances for profit for the creative trader are infinite with this flexible instrument. It is also a good indicator for long-term investors to follow since it indicates that higher volatility is likely if the ATR value has stayed reasonably consistent for longer periods of time. They would therefore be prepared for what may be a tumultuous market ride, preventing fear in dips and undue enthusiasm if the market breaks higher.

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