The indicator known as average true range (ATR) can be used to develop a complete trading system or be used for entry or exit signals as part of a strategy. Professionals have used this volatility indicator for decades to improve their trading results. Find out how to use it and why you should give it a try.

What Is ATR?
The average true range is a volatility indicator. Volatility measures the strength of the price action, and is often overlooked for clues on market direction. A better known volatility indicator is Bollinger Bands®. In "Bollinger on Bollinger Bands®" (2002), John Bollinger writes that "high volatility begets low, and low volatility begets high." Figure 1, below, focuses solely on volatility, omitting price so that we can see that volatility follows a clear cycle.

Figure 1
Source: GenesisFT.com

How close together the upper and lower Bollinger Bands® are at any given time illustrates the degree of volatility the price is experiencing. We can see the lines start out fairly far apart on the left side of the graph and converge as they approach the middle of the chart. After nearly touching each other, they separate again, showing a period of high volatility followed by a period of low volatility. (For more, see Basics Of Bollinger Bands®.)

Bollinger Bands® are well known and they can tell us a great deal about what is likely to happen in the future. Knowing that a stock is likely to experience increased volatility after moving within a narrow range makes that stock worth putting on a trading watch list. When the breakout occurs, the stock is likely to experience a sharp move. For example, when Hansen (Nasdaq:HANS) broke out of that low volatility range in the middle of the chart (shown above), it nearly doubled in price over the next four months.

The ATR is another way of looking at volatility. In Figure 2, we see the same cyclical behavior in ATR (shown in the bottom section of the chart) as we saw with Bollinger Bands®. Periods of low volatility, defined by low values of the ATR, are followed by large price moves.

Figure 2
Source: GenesisFT.com

Trading With ATR
The question traders face is how to profit from the volatility cycle. While the ATR doesn't tell us in which direction the breakout will occur, it can be added to the closing price and the trader can buy whenever the next day's price trades above that value. This idea is shown in Figure 3. Trading signals occur relatively infrequently, but usually spot significant breakout points. The logic behind these signals is that whenever price closes more than an ATR above the most recent close, a change in volatility has occurred. Taking a long position is a bet that the stock will follow through in the upward direction.

Figure 3
Source: GenefisFT.com

ATR Exit Sign
Traders may choose to exit these trades by generating signals based on subtracting the value of the ATR from the close. The same logic applies to this rule - whenever price closes more than one ATR below the most recent close, a significant change in the nature of the market has occurred. Closing a long position becomes a safe bet, because the stock is likely to enter a trading range or reverse direction at this point. (For related reading, see Retracement Or Reversal: Know The Difference.)

The use of the ATR is most commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the "chandelier exit" and was developed by Chuck LeBeau. The chandelier exit places a trailing stop under the highest high that the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade. (For related reading, see Trailing-Stop Techniques.)

The value of this trailing stop is that it rapidly moves upward in response to the market action. LeBeau chose the chandelier name because "just as a chandelier hangs down from the ceiling of a room, the chandelier exit hangs down from the high point or the ceiling of our trade."

The ATR Advantage
ATRs are, in some ways, superior to using a fixed percentage because they change based on the characteristics of the stock being traded, recognizing the fact that volatility varies across issues and market conditions. As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader's desire to protect profits with the necessity of allowing the stock to move within its normal range. (For more, see A Logical Method Of Stop Placement.)

ATR breakout systems can be used by strategies of any time frame. They are especially useful as day trading strategies. Using a 15-minute time frame, day traders add and subtract the ATR from the closing price of the first 15-minute bar. This provides entry points for the day, with stops being placed to close the trade with a loss if prices return to the close of that first bar of the day. Any time frame, such as five minutes or 10 minutes, can be used. This technique may use a 10-period ATR, for example, which includes data from the previous day. Another variation is to use a multiple of ATRs, which can vary from a fractional amount, such as one-half, to as many as three (beyond that there are too few trades to make the system profitable). In his 1990 book, "Day Trading with Short-Term Price Patterns and Opening Range Breakout", Toby Crabel demonstrated that this technique works on a variety of commodities and financial futures.

Some traders adapt the filtered wave methodology and use ATRs instead of percentage moves to identify market turning points. Under this approach, when prices move three ATRs from the lowest close, a new up wave starts. A new down wave begins whenever price moves three ATRs below the highest close since the beginning of the up wave. (For more insight, see Surf's Up With Filtered Waves.)

Conclusion
The possibilities for this versatile tool are limitless, as are the profit opportunities for the creative trader. It is also a useful indicator for the long-term investors to monitor because they should expect times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods of time. They would then be ready for what could be a turbulent market ride, helping them avoid panicking in declines or getting carried way with irrational exuberance if the market breaks higher.

Related Articles
  1. Chart Advisor

    Breakout Opportunity Stocks: CPA, GNRC, WWE

    After a period of contracting volatility, watch for breakouts and bigger moves to come in these stocks.
  2. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  3. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  4. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  5. Options & Futures

    Contango Versus Normal Backwardation

    It’s important for both hedgers and speculators to know whether the commodity futures markets are in contango or normal backwardation.
  6. Stock Analysis

    3 Risks U.S. Equities Face in 2016

    Find out why the probability of a U.S. stock bear market is increasing in 2016 and what the greatest risks are to the bull market that is almost 7 years old.
  7. Chart Advisor

    Watch For a Bounce in These Emerging Markets (BRF, PEK)

    While downtrends are clearly in control of the direction of many emerging market ETFs, short-term indicators suggest a bounce higher could be in the cards.
  8. Investing Basics

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  9. Investing Basics

    What Does Contango Mean?

    Contango​ is when the futures price of a commodity is higher than the expected future spot price.
  10. Chart Advisor

    Watch For Stock Breakouts Here

    Four stocks with potential breakouts across various time frames and pattern.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center