Average True Range (ATR) for Traders

Average True Range (ATR) measures market volatility, helping traders set appropriate stop-losses, position sizes, and profit targets based on actual market movement. [DEFINITION] Average True Range (ATR): A volatility indicator that measures the average range of price movement over a specified period, accounting for gaps. Higher ATR = more volatile; lower ATR = less volatile. ### Calculating ATR True Range is the greatest of: 1. Current High - Current Low 2. |Current High - Previous Close| 3. |Current Low - Previous Close| [FORMULA] ATR = Average of True Range over N periods (typically 14) This captures both intraday range and gap movements. ### Reading ATR Values [EXAMPLE] Stock XYZ: - Price: $50 - 14-day ATR: $2.50 This means the stock moves an average of $2.50 per day (5% of price). A $100 stock with ATR of $2.50 would be less volatile (2.5%). [KEY] ATR is measured in price, not percentage. A $2 ATR on a $20 stock (10% volatility) is different from $2 ATR on a $100 stock (2% volatility). ### Using ATR for Stop-Losses **ATR-based stops adapt to volatility:** - Volatile stocks get wider stops - Calm stocks get tighter stops - Reduces premature stop-outs **Common methods:** - 2 × ATR from entry - 1.5 × ATR from recent swing - 1 × ATR trailing stop [EXAMPLE] You buy at $50, ATR is $2. A 2× ATR stop = $50 - $4 = $46 stop-loss. This respects the stock's natural movement, reducing the chance of being stopped out by normal volatility. ### ATR for Position Sizing **Volatility-based position sizing:** Risk a fixed dollar amount per ATR, not per share. [FORMULA] Position Size = Risk per Trade ÷ (N × ATR) Where N is your ATR multiplier for stops. [EXAMPLE] - Account: $100,000 - Risk per trade: 1% = $1,000 - Stock price: $50 - ATR: $2.50 - Using 2 × ATR stop = $5 risk per share - Position size: $1,000 ÷ $5 = 200 shares This equalizes risk across different volatility stocks. ### ATR for Profit Targets **ATR-based targets:** - Target profit: 2-3 × ATR from entry - Aligns with what the stock can realistically move - Avoids unrealistic expectations [TIP] If ATR is $3, setting a $1 profit target is leaving money on the table. Setting a $15 target (5x ATR) may be unrealistic for a single move. ### ATR Trends and Analysis **Rising ATR:** - Volatility increasing - Often at trend changes - Wider stops may be needed **Falling ATR:** - Volatility decreasing - Consolidation forming - Breakout may be coming **Extreme ATR:** - Volatility spike - Often near panic/capitulation - Risk management crucial ### Comparing Volatility ATR helps compare volatility across stocks: - Convert to percentage: ATR / Price × 100 - Called "ATR percentage" or normalized ATR - Allows apples-to-apples comparison [EXERCISE] Stock A: Price $100, ATR $5. Stock B: Price $25, ATR $2. Which is more volatile? |ANSWER| Stock A: ATR/Price = 5/100 = 5%. Stock B: ATR/Price = 2/25 = 8%. Stock B is more volatile despite lower absolute ATR. Normalized ATR allows proper comparison. ### Practical ATR Workflow 1. **Check ATR before entering:** Know what you're dealing with 2. **Set stop-loss based on ATR:** Respects natural volatility 3. **Size position using ATR:** Equalizes risk across trades 4. **Set targets using ATR:** Realistic expectations 5. **Monitor ATR changes:** Adjust strategy if volatility shifts ### ATR in Different Timeframes **Daily ATR:** Best for swing and position traders **Weekly ATR:** Useful for longer-term holdings **Hourly/15-min ATR:** Day traders use shorter periods Match ATR timeframe to your trading timeframe. [WARNING] ATR is backward-looking. Volatility can spike suddenly. ATR tells you what happened, not what will happen. [SCENARIO] You're comparing two trades: Trade A in a $50 stock with $3 ATR (6%), Trade B in a $200 stock with $4 ATR (2%). With $10,000 to allocate, how should you think about position sizing? Equal dollar allocation: $5,000 each creates unequal risk. Trade A is 3× more volatile. Better approach: Use ATR-based sizing. If risking 2× ATR per trade and wanting $500 total risk: Trade A: $500 ÷ (2 × $3) = 83 shares ($4,150). Trade B: $500 ÷ (2 × $4) = 62 shares ($12,400). This normalizes risk but requires more capital for low-volatility Trade B. Adjust position sizes to match your available capital while maintaining risk parity.