Average True Range (ATR)

Average True Range measures volatility without indicating direction. It's essential for position sizing, stop-loss placement, and understanding how much a stock typically moves. [DEFINITION] Average True Range (ATR): A volatility indicator showing the average range between high and low prices, accounting for gaps, typically calculated over 14 periods. ### Calculating True Range True Range is the GREATEST of: 1. Current High - Current Low 2. Absolute value of (Current High - Previous Close) 3. Absolute value of (Current Low - Previous Close) [TIP] The inclusion of previous close captures gap volatility that high-low range alone would miss. ### Interpreting ATR **High ATR:** High volatility, big daily swings **Low ATR:** Low volatility, small daily moves **Rising ATR:** Volatility increasing **Falling ATR:** Volatility decreasing [EXAMPLE] Stock A: Price $100, ATR $5 (5% daily range) Stock B: Price $100, ATR $2 (2% daily range) Stock A moves 2.5x more than Stock B on an average day. ### Using ATR for Stop-Losses **ATR-based stops account for normal volatility:** [FORMULA] Stop Distance = Entry Price - (ATR × Multiplier) Common multipliers: 1.5x, 2x, or 3x ATR [EXAMPLE] Buy at $100, ATR is $3. - 2x ATR stop = $100 - ($3 × 2) = $94 This stop is wide enough to allow for normal volatility while still protecting against abnormal moves. [KEY] Stops based on ATR adapt to the stock's actual volatility. A 5% stop on a stock with 3% daily ATR is much different than 5% on a stock with 10% daily ATR. ### Position Sizing with ATR **ATR-based position sizing ensures consistent risk:** [FORMULA] Position Size = Dollar Risk ÷ (ATR × Multiplier) [EXAMPLE] You're willing to risk $500. ATR is $2, using 2x ATR stop ($4). Position Size = $500 ÷ $4 = 125 shares If the stop is hit, you lose approximately $500 regardless of the stock's volatility. ### ATR for Profit Targets **ATR can project realistic targets:** - Conservative: 1x ATR - Moderate: 2x ATR - Aggressive: 3x ATR [EXAMPLE] Entry at $100, ATR $5. - 2x ATR target = $100 + $10 = $110 This target accounts for what the stock actually does, not arbitrary percentages. ### Volatility Contraction/Expansion [WARNING] Low ATR often precedes large moves (volatility expansion). High ATR often precedes consolidation (volatility contraction). **Squeeze setup:** ATR at multi-month low, then breakout **Climax warning:** ATR at multi-month high after extended move [EXERCISE] You want to risk no more than $1,000 on a trade. A stock trades at $50 with ATR of $2. You plan to use a 2x ATR stop. How many shares can you buy? |ANSWER| Stop distance = 2 × $2 = $4. Position size = $1,000 ÷ $4 = 250 shares. At $50/share, this is a $12,500 position with $1,000 at risk. [SCENARIO] You're comparing two stocks for a swing trade: - Stock A: $80, ATR $8 (10% daily volatility) - Stock B: $80, ATR $2 (2.5% daily volatility) For Stock A, a $4 stop is only 0.5 ATR—likely to get stopped on normal fluctuations. You'd need at least $12-16 (1.5-2 ATR) for a reasonable stop. Stock B can use a tighter absolute dollar stop while still giving the trade room to work. Understand volatility before setting stops.