Trader's Daily Notebook: What Is Average True Range?

 | Jun 09, 2017 | 7:00 AM EDT
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Much of our focus in Trader's Daily Notebook centers around day timeframe trading. But given the increased requests for more active discussions on intermediate and higher timeframe ideas, I thought we'd spend some time digging into the average true range (ATR) and study what makes it such an essential part of a trader's toolbox. 

Let's begin with a bit of background. 

The ATR is an indicator used to measure the volatility of an instrument. It can be used on stocks, just as easily as on commodity, currency and equity futures. It was developed by J. Welles Wilder and introduced to the trading community in his 1978 book, New Concepts in Technical Trading Systems

The math behind an instrument's true range is incredibly straightforward. It's simply the largest value of the following three equations: 

  1. True range = today's high - today's low
  2. True range = today's high - yesterday's close
  3. True range = yesterday's close - today's low 

Once the largest value of the three equations is identified, an exponential moving average is applied to the true range and we're left with the average true range. Thankfully, every modern-day charting program is capable of calculating ATR as easy as it can spit out a dozen different moving averages. Put another way, we don't need to worry about the actual equations the way Welles Wilder did in the late 1970s. 

Most traders hear the word "indicator" and they think of moving averages, Relative Strength Index (RSI), moving average convergence divergence (MACD) or stochastic oscillators. Rarely does one think of an ATR, but they should. While some may like staring at an RSI or MACD, it's the ATR that we're able to build our initial, protective and trailing stops around. And as anyone who has traded for more than a couple of years already knows, it's risk and position management, not setups and chart patterns, that determine long-term profitability. 

When used for risk management, ATR can be implemented numerous ways. Some traders like to run a multiple-based ATR stop, meaning if a trader were long an instrument, a trailing or protective stop would be placed at a predetermined multiple of ATR from that instrument's swing high. 

For example, if stock ABC is trading at $50, the 10-day ATR is $1 and the trader wants to use a trailing 5 ATR stop, the current stop would be placed at $45. As volatility increases, so would the stop in order to prevent random volatility, or noise, from stopping the trader out of the position. And as volatility decreases, the stop would become smaller to account for range contraction. 

Another method, and the one I generally use, is to add or subtract (based on trade direction) a multiple of ATR to a moving average. In this case, if a trader were buying a stock and using the 50-day simple moving average as his trigger point, he might then subtract one or two ATRs from that moving average for his stop. The reason for subtracting a measure of volatility from the moving average is, again, to prevent random or inconsequential volatility (noise) from triggering a stop. 

As with all aspects of trading, the correct level of ATR-related risk is going to be unique to each trader's tolerance for risk. That said, we generally want a stop that, if triggered, provides a reliable indication, based on our timeframe, that we should be out of the trade. 

I hope this primer on average true range makes sense, because in Monday's Trader's Daily Notebook we're going to apply it to some charts. Enjoy your weekend. 

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