The technical indicator Average True Range (ATR) is an indicator of market volatility. It was introduced by Welles Wilder in his book “New Concepts of Technical Trading Systems” and since then the indicator has been used as a component of many other indicators and trading systems. This is a fairly popular indicator included in most market analysis software. Its main purpose is to set the correct Stop Loss levels. This is the most effective method of setting stops, which is proven by statistics.
Average True Range also serves as a trend filter. It can be interpreted according to the same rules as other volatility indicators. The principle of forecasting using ATR is formulated as follows: the higher the indicator value, the higher the probability of a trend change; the lower its value, the weaker the trend direction. A detailed overview of the indicator in today’s material.
The Average True Range indicator is a moving average of the true range values:
Average True Range = SMA (TR, N), where TR is the true range, N is the averaging period, SMA is the simple moving average.
From the settings for the ATR indicator, only the averaging period is available, which by default is 14.
How do I place a stop loss based on volatility?
The ATR indicator reflects the maximum movement of the asset price for the period.
In order to calculate a protective order by ATR, you need to take the current value of the volatility indicator and postpone it from the average price. The moving average value can be used as the average price. So, if we consider the entry from the average, for example, from the EMA (13), then depending on the direction of trade, the stop loss (SL) can be calculated as:
- SL (long) = EMA(13) – 2 x ATR
- SL (short) = EMA(13) + 2 x ATR
Why take two ATRs? Because if you use 2 x ATR, then the probability that the stop will be in their limit is 95%. If you reduce the range, for example, to one ATR, then the chances of this are reduced to 68%. This is how the law of normal distribution works, and I try to respect it when looking for a compromise between position size and risk.
Analysis of a trade using the ATR indicator
Consider as an example long trade with Amkor Technology (NASDAQ: AMK).
We will enter at $ 10.85, take profit at $ 11.50. Where are we going to place a stop taking into account the standard deviation (SD) and the average true range (ATR)? Let’s count now.
Trade with a stop at ATR:
Stop order: $ 10.2.
EMA (13) ($ 11.06) – 2 x ATR ($ 0.86) = $ 10.2
$ Stop: 0.65 (10.85 – 10.2)
Stop in%: 6% (0.65 / 10.85)
Profit $: 0.65 (11.50 – 10.85)
Profit in%: 6% (0.65 / 10.85) Risk / reward ratio: 1: 1.
Obviously, a long position in AMKR with a stop loss (by SD) at $ 10.54 can be opened. While the option with a stop (by ATR) at $ 10.2 and with a risk / reward ratio of 1: 1 – egg broth – does not make sense. As you can see, there is nothing complicated in this method.
More profitable indicators for forex and stock trading: forex indicators without repainting.