Average True Range or ATR Indicator Strategy, Formula

Average True Range

Average True Range indicator, popularly known as ATR shows the historical price movement of a stock over a specific period of time. Though it is similar to historical volatility, ATR shows the average range of price movement of a stock over a specific period of time whereas the historical volatility of a stock is always calculated annually. With the ATR known for a particular period of time, we can presume whether the stock is topping or bottoming out. The ATR line slope also indicates whether the stock is more volatile or not.

Average True Range has been introduced by J. Welles Wilder. In simple terms, the ATR indicator measures the volatility. A rising ATR denotes that the volatility is increasing and a falling ATR denotes that the volatility is dying down. Generally, ATR is calculated on a 14-period or a 21-period basis.

Average True Range FAQ

What is ATR in stock?

ATR in the stock market means the average true range. Range means today’s high minus today’s low. True Range is the highest of today’s range or absolute value of today’s high minus yesterday’s close or the absolute value of today’s low minus yesterday’s close. Average True Range is the moving average of this True Range.

What does ATR measure?

The ATR indicator measures volatility. So if this indicator moves up the volatility increases and if the indicator moves down then the volatility decreases. So it is directly proportional to volatility.

How to set up the Average True Range?

ATR Indicator on Zerodha Kite

  • Open your MarketWatch on Zerodha Kite.
  • Choose your stock or commodity.
  • Right-click on it and open its chart
  • Go to Average True Range in the Studies section and click on it.
  • The parameter window opens with default parameters of the ATR indicator.
  • Once we choose the default parameter or change as per our need, the Average True Range is plotted on the screen.
  • By default, the indicator’s parameter is 14-period for plotting the chart, but we can always change it.
ATR Indicator Zerodha

ATR Indicator on Upstox Pro

Similarly, you can plot the average true range on the Upstox Pro platform. Here too you can change the default parameter as per your need. Check the image below.

ATR Indicator Upstox

How does the Average True Range Work?

  • Low ATR indicator value indicates very low volatility and a sideways trend.
  • On the other hand, a high Average True Range value indicates the price is volatile and is definitely trending.
  • When the indicator bottoms out and starts going up sharply, it shows price is going to break out from the existing range with a definite trend.
  • It works well when combined with other indicators.

Using a Moving Average of the ATR Indicator

  • To judge whether the volatility will fall or rise we can use a moving average of the ATR indicator.
  • When the Average True Range crosses the moving average from below it is the signal that volatility will start to rise.
  • Watch the image below where we have used a Hull Moving Average of the ATR.
Moving Average of Average True Range

How to Catch Exact Top and Bottom of the Market with ATR Indicator?

Can you catch the exact top or bottom of the market? Do you know there can be a strategy that can tell you on the intraday basis that the market has reached an extreme? Suppose you are seeing that Nifty has suddenly fallen for 60 odd points OR say, Crude Oil has risen by 40 points. Do you think that the scrips will go more extreme? If your answer is YES, then you are wrong.

Maximum times the market will reverse back from an extreme instead of moving further into the extreme. But how to identify that the market has reached an extreme? There comes the use of a technical indicator called the ATR indicator.

Using the Daily Volatility to Predict the Probable Range

Watch the image below. There I have shown the Nifty index chart with a 14-day ATR indicator. Check the 14-day ATR of the Nifty index is 78.541.

ATR Indicator

This means that the average true range of the Nifty index is 78.541. Now say next day Nifty starts falling since the open and is almost 70-80 points down. Shall you open new short OR hold any existing short in Nifty? NO. As Nifty has almost fallen its average true range there is a high chance that Nifty will bounce back as its already completed its range. So, we will open up a BUY order with a suitable stop value.

Similarly, the ATR indicator can suggest you a SHORT SELL level in times of rallies. We will not get sure shot trades every day as per this strategy, but whenever we will get a trade that can be very accurate. You can use this strategy of indices, stocks as well as commodities.

The ATR Bounce Trading System

I named this trading strategy value as ATR Bounce Trading Strategy OR ATR Bounce Trading System. The idea of the ATR Bounce Trading System is very simple. Just watch the daily reading of the 14-day ATR OR Average true range indicator or a particular stock or index or commodity. Suppose the closing price of the stock, index or commodity today is X and suppose today’s ATR reading is Y, then I derive tomorrow’s maximum high OR low from the below-mentioned formula.

Maximum high next day = X+Y
Maximum low next day = X-Y

So it is easy to find tomorrow’s range using the ATR indicator. Now how to trade the system? Next day whenever the stock/ index/commodity will move towards the maximum high open a short trade with a tight stop with a moderate target. For a long trade whenever the stock/ index/commodity will move near to the maximum low open a long trade with a tight stop with a moderate target.

Now, a classic example of the ATR Bounce Trading System was seen in the Nifty index yesterday, i.e. 15th February 2017. Last day, i.e, 14th February Nifty closed at 8792.30 and the 14-day ATR value was 76. So, the next day’s long level was 8792-76 = 8716 and the short level was 8792+76 = 8868. Now let’s check the exact scenario. Check the image below:

Average True Range Bounce Trading System

The Nifty index opened, could not move higher and slipped towards maximum low zone to find exact bounce from 8713, super profit within a few minutes, a spike from 8713 to 8750.

Using the ATR Indicator to Identify Stop Loss

The Average True Range is also used to predict correct stop loss. Suppose many traders keep the stop loss at certain multiples of the ATR. A common usage is to keep the stop loss at 1 ATR or 1.5 ATR value.

Suggested Reading

I will suggest you read this book: Average True Range: Your Step-by-Step Guide to Profitable Forex Trading with Average True Range.

Conclusion

The Average True Range indicator works well in judging the volatility of the markets. Traders can use this technical indicator to understand the market trend strength. The common way of understanding whether the volatility is rising or dying down is to use the ATR with one of its moving average (MA). Another common usage of ATR can be in predicting the exact top or bottom in intraday. This post on the ATR bounce trading system can elaborate more on the usage of this indicator.

NEW TO STOCK MARKET?

Don't Start Trading Until You Read This Free Ebook..

READ THIS FREE EBOOK TO LEARN...

  • 4 rules of making millions in the stock market.
  • How to follow these rules in your investing.
  • How to retire as a multi millionaire.

Author: Indrajit Mukherjee

Indrajit is a professional blogger and trading system developer. Amibroker expert, Wordpress expert, SEO expert and stock market analyst.Trading since 2002, he has started the journey of StockManiacs.net on 2008. He follows Indian and world stock markets closely.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.