How to trade average true range

We look at the average true range, and how it can be used in trading and stop placement.

Chart
Source: Bloomberg

The average true range (ATR) is an indicator designed to measure the volatility of an asset. It is calculated by taking the moving average, usually 14 days, of the true range. The true range is the largest of the following three:

  • the current high minus the current low
  • the value of the current high minus the previous close
  • the value of the current low minus the previous close

It was originally developed to measure volatility in commodities, but like many indicators it has found use for all markets. It allows traders to measure the daily volatility of an asset, and whether this is increasing or decreasing, and thus used as an aid to position sizing and stop placing. It does not indicate price direction, but instead tracks how much an asset moves in a given time period.

The chart below shows the FTSE 100, with a 14-day ATR. From the middle of the month ATR begins to rise, as the index experiences heightened volatility:

ATR can be utilised for stop placement. A higher ATR reading suggests greater intraday volatility, and thus stops should be wider in order to avoid having a position stopped out on a sudden swing. With wider stops, of course, it follows that position sizes will be smaller, if traders are following (as they should be) the rule that no trade risks more than 2% of your account size.

Thus, taking the example from above, a stop utilising the ATR method placed on a trade in the middle of the month, when the ATR was around 20, will be narrower than on a trade in late January, when ATR is 26.

A common method of using ATR in stop placement involves using multiples of ATR, perhaps twice the current ATR level (known as ‘2ATR’). This means that the possibility of a trade being stopped out by a sudden volatile move is reduced, since it is rare to see the price move by twice the ATR.

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