Average True Range Trading Strategy (Best ATR Indicator, Settings and System) - VIDEO

The ATR indicator is useful on its own and can be used to develop an Average True Range trading strategy. The Average True Range (ATR) was developed by Welles Wilder in the 1970s. In his famous book called New Concepts in Technical Trading Systems, published in 1978, Wilder also published the RSI and the ADX indicators.

In this article, we look at the Average True Range (ATR) indicator. We explain what the Average True Range indicator is, how it works, how you can use it, and if it’s possible to make profitable strategies by using the ATR. We show you why ATR is a useful indicator.

Welles Wilder was ahead of his time; this was well before the computer age, and all his indicators have stood the test of time and are still widely used. To this day, the RSI is probably the most popular trading indicator on the planet.

Table of contents:

Key takeaways

The Average True Range (ATR), introduced by Welles Wilder in 1978, is a technical analysis indicator that measures market volatility by calculating the average range between high and low prices over a specified period.
It provides insight into the degree of price movement, aiding traders in assessing market conditions.
Key Takeaways:

Calculation of ATR:
- True Range (TR): The greatest value among:
  - Current high minus current low
  - Absolute value of current high minus previous close
  - Absolute value of current low minus previous close
- Average True Range (ATR): Typically computed as a 14-period moving average of the True Range, but this is most likely not the best setting (for stocks).
ATR as a Volatility Measure: ATR reflects market volatility without indicating price direction. Higher ATR values signify increased volatility, while lower values suggest calmer market conditions.
Applications of ATR in Trading:
- Volatility Filter: Traders can filter assets based on ATR values to focus on instruments matching their risk tolerance and strategy preferences.
- Stop-Loss Placement: ATR aids in setting stop-loss levels that adapt to market volatility. For instance, a stop-loss might be placed 1.5 times the ATR below the entry price for long positions.
- Position Sizing: ATR informs position sizing by adjusting the trade size according to market volatility, helping maintain consistent risk levels.
- Strategy Development: ATR can be integrated into trading strategies, such as the ATR Channel Breakout, where channels are set based on ATR to identify potential breakouts.

What is the Average True Range (ATR indicator)?

If you are interested in the ATR indicator, you might find our take on the Range Expansion Index (REI) interesting.

The Average True Range is a mathematical indicator that sets to measure the range of price changes. The ATR is calculated in two steps – the true range and the average of the true range:

How to calculate the True Range

The true range is the greatest of these three calculations:

High minus the previous close
High minus low
The previous close minus low

How to calculate the Average True Range

When we know the true range of each day/bar, we calculate it by using x-day/bar of the maximum range every day.

In this article, we use the built-in ATR in Amibroker, which is based on Wilder’s original formula in the book mentioned above. Wilder used a smoothed moving average built upon an exponential moving average. Read more here for the difference between simple and moving averages: Are moving averages good or useless?

The Average True Range is a volatility measure

As you might have guessed the ATR is first and foremost a volatility measure that gives you no clue about the direction of the price: it could be up or down. However, volatility typically picks up when the markets are uncertain.

The chart below shows the 15-day ATR in QQQ (Nasdaq):

During COVID-19 in March and April 2020, the volatility was very high, but it has since cooled off.

How to use the Average True Range indicator

There are many ways to use the ATR. Below, you will find the four most obvious ways to use ATR:

Average True Range as a volatility filter

The ATR is frequently used as a volatility filter. You can, for example, scan stocks to filter out both low and high volatility stocks. Some stocks perform better than others, and you might want certain stocks within a sub-sector based on volatility. Volatility is often a very good filter.

Average True Range as stop-loss

ATR is often used to set stop-loss levels. For example, you can put a stop loss 1.5 times ATR lower than the entry price (if you are long). If your entry is 100 and the 20-day ATR is 5.5, then your trigger point for the stop-loss is 91.75 (100 minus 5.5 times 1.5). In other words, if the price drops to 91.75 you sell to cut your losses.

True Strength Index

Please remember that the True Strength Index is entirely different from the Average True Range.

Average True Range as position sizing

Another way to use ATR is to adjust position sizing. If you are trading a portfolio of ten stocks, each of them might have different volatility. It doesn’t make sense to trade the same size in stocks that might be completely different in terms of volatility.

For example, let’s say you have a portfolio of ten stocks that you trade on a rotational basis. To adjust for volatility you can take 10 000 (or whatever number you set as default) and divide by the Average True Range over the last 100 days. This way you allocate more capital to the least volatile stocks compared to the ones more volatile.

Average True Range can be used to build trading strategies

Furthermore, you can build trading strategies based on the ATR, mostly mean-revertive strategies. However, most of these strategies are often overlapping trades with the RSI (for example). Below, you find some examples of how to develop such strategies:

The Average True Range strategy video

How to use Average True Range in the S&P 500

Of course, average true range can be used on any financial asset, even crypto. However, the most traded asset in the US is indices for stocks, and below, we have provided some examples of very simple strategies. They are profitable, but they need to be worked upon to be used as stand-alone strategies.

Let’s first test using a straightforward hypothesis:

Buy when the close is below a moving average deducted from the Average True Range, and sell when the opposite is true. The code in Amibroker is like this:

Trading Rules

Buy = C < MA(C,10) – (ATR(10)*1.5);
buyPrice = Close;
Sell = C>MA(C,10) + (ATR(10)*1.5);
sellPrice = Close ;

In plain English, it reads like this:

Trading Rules

Buy when the close is below the ten-day moving average of the closing price deducted the ten-day Average True Range multiplied with 1.5. Sell when the opposite is true.

Both the entry and the exit are done at close.

On the S&P 500, we get this equity curve:

This is, to say the least, not tradeable. What happens if we lower the exit criteria? Let’s exit when the close is higher than the 10-day moving average:

Buy = C < MA(C,10) – (ATR(10)*1.5);
buyPrice = Close;
Sell = C>MA(C,10);
sellPrice = Close ;

The equity curve improves, but it’s still not tradeable:

What happens if we perform the last strategy on Nasdaq? On the ETF QQQ we get this equity curve:

It’s better, but still not acceptable.

Nevertheless, the strategy can still be improved. We added two more variables to the buy criteria and changed the exit. The strategy has improved a lot, both on the Nasdaq and the S&P 500. This is the new equity chart for Nasdaq from the year 2000 until today:

Even if we ignore the best trades before 2004, the result is pretty good: the profit factor is 3.1.

If we use the same system on the S&P 500, the equity curve improves as well:

Both of the above equity charts are based on swing trading, where the holding period is a few days.

The last strategy above produces this equity curve if we exit on the next day open:

If you want to have the code for the strategy producing the three last equity charts (including Amibroker and Tradestation code plus “plain English”), you can order it via this link (ATR Strategy no. 1).

You can subscribe to our memberships where we send out ideas like this monthly.

Conclusion

Average True Range can be used as a trading tool in many ways. It’s a versatile instrument that can be used for position sizing, finding stop-loss levels, volatility filters, and building trading strategies. It’s such a useful indicator that it can be used on its own to develop an Average True Range strategy.

Glossary – Average True Range (ATR)

You don’t need to be intimidated by the unknown terms. ATR is a specific term for trading fanatics, so here is a list of the most important phrases for the ATR indicator:

Average True Range (ATR): A technical indicator that measures market volatility by calculating the average range between high and low prices over a specified period. It helps traders assess the potential price movement.
ATR Indicator: A graphical representation of the Average True Range on a price chart, often used to identify volatility trends.
Volatility: The degree of variation in a financial instrument’s price over time. A high ATR suggests high volatility, while a low ATR indicates low volatility.
ATR Period: The number of periods or days used to calculate the Average True Range. Common periods include 14, 20, or 50.
ATR Setting: The specific configuration chosen for the ATR indicator, such as the period length or the type of moving average applied to the ATR.
ATR Stop Loss: A trading strategy that uses the ATR to determine stop loss levels, allowing for greater flexibility in adjusting to market conditions.
ATR Trailing Stop: A dynamic stop-loss technique that trails the stop level based on changes in the ATR, allowing traders to lock in profits as prices move in their favor.
ATR Breakout: A trading strategy that identifies potential breakouts by monitoring ATR levels. Breakouts occur when prices move beyond recent ATR boundaries.
ATR Channel: A price channel formed by plotting ATR values above and below a moving average. Traders use it to identify potential reversal points.
ATR Bands: Bands created by adding and subtracting a multiple of the ATR from a moving average. They help traders identify potential support and resistance levels.
Volatility: Refers to the degree of variation of a trading price series over time, indicating how much an asset’s price can vary.
Technical Analysis: A methodology for forecasting the direction of prices through the study of past market data, primarily price and volume.
Market Indicators: Statistical metrics used to gauge the condition of the stock market or the economy, helping traders make informed decisions.
Trading Strategies: Plans of action designed to achieve a profitable return by going long or short in markets.
Risk Management: The process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.
Price Movement: The change in price of an asset over a period of time, which can be upward, downward, or sideways.
Trend Analysis: A technique used in technical analysis that attempts to predict future stock price movements based on recently observed trend data.
Stop Loss Orders: An order placed with a broker to buy or sell once the stock reaches a certain price, designed to limit an investor’s loss on a security position.
Position Sizing: The process of determining the amount of capital to be allocated to a trade, based on the total account size and risk level.
Momentum Trading: A strategy that aims to capitalize on the continuance of existing trends in the market.
Swing Trading: A type of trading aimed at capturing short to medium-term gains in a stock (or any financial instrument) over a period of a few days to several weeks.
Day Trading: The practice of buying and selling a security within a single trading day.
Scalping: A trading strategy that attempts to profit from small price changes, often exiting a trade within minutes.
Financial Markets: Platforms where buyers and sellers participate in the trade of assets such as equities, bonds, currencies, and derivatives.
Forex Trading: The act of buying and selling currencies with the aim of making a profit from the changes in their value.
Stock Trading: The buying and selling of shares in companies with the aim of making a profit.
Commodity Trading: The buying and selling of goods such as oil, gold, and coffee on the commodities market.
Cryptocurrency Trading: The act of speculating on cryptocurrency price movements via a CFD trading account, or buying and selling the underlying coins via an exchange.
Price Action: The movement of a security’s price plotted over time, which is used by traders to make trading decisions.
Candlestick Patterns: A style of financial chart used to describe price movements of a security, derivative, or currency.
Support and Resistance: Price levels on charts that indicate where the prices of assets tend to stop and reverse.
Breakout Trading: A strategy where traders enter the market when the price moves outside a defined price range (support or resistance).
Chart Patterns: Distinctive patterns that are formed on a chart, indicating the future direction of an asset’s price.
Moving Averages: Indicators used to analyze price movements by smoothing out price fluctuations into a single flowing line, indicating trends.
ATR Volatility Expansion: A market condition where the ATR expands, indicating increased price volatility and potential trading opportunities.
ATR Volatility Contraction: A market condition where the ATR contracts, signaling reduced price volatility and possible consolidation.
ATR Range: The range of prices encompassed by the ATR value, indicating the average distance between high and low prices.
ATR Multiplier: A constant used to multiply the ATR value in certain strategies, helping traders adjust to different market conditions.
ATR Breakout Strategy: A trading approach that seeks to capitalize on price breakouts by using the ATR to set entry and stop-loss levels.
ATR Trend Following: A trading strategy that combines ATR with other indicators to identify and follow trends in the market.
ATR Reversal: A trading strategy that uses ATR to identify potential trend reversals, providing signals to enter or exit trades.
ATR Divergence: A situation where the ATR and price movement show conflicting signals, often used to identify potential trend reversals.
ATR Oscillator: An indicator derived from the ATR that oscillates above and below a centerline, helping traders identify overbought or oversold conditions.
ATR Percentage Stop: A stop-loss technique where traders use a percentage of the ATR value to set their stop levels.
ATR Range Expansion: A sudden increase in ATR values, indicating a significant shift in market conditions and potentially tradable trends.
ATR Range Contraction: A period of decreasing ATR values, suggesting a lack of volatility and potential consolidation.
ATR Breakout Confirmation: Waiting for the ATR to confirm a breakout before entering a trade to reduce false signals.
ATR Position Sizing: A risk management technique that determines the size of a position based on the ATR, helping to manage risk in volatile markets.
ATR Moving Average: A moving average calculated from the ATR values, providing a smoothed representation of volatility.
ATR Trade Filter: A method of filtering potential trades based on specific ATR conditions to improve trading accuracy.
ATR Range Bar: A type of price chart where each bar’s range is determined by the ATR, helping traders visualize volatility.
ATR Standard Deviation: A statistical measure of how much the ATR values deviate from the average ATR, useful for assessing extreme market conditions.
ATR Breakout Pullback: A trading strategy that involves entering a trade after a price breakout, then waiting for a pullback to the ATR level before entering.
ATR Range Projection: Estimating potential price movement by projecting ATR values into the future, assisting with setting profit targets.
ATR Position Reversal: A strategy that uses ATR to identify when to reverse a position, switching from long to short or vice versa.
ATR Swing Trading: A trading style that aims to capture short to medium-term price swings using ATR-based entry and exit points.
ATR Risk-Reward Ratio: Evaluating potential trades by comparing the expected price movement based on ATR to the risk of the trade.
ATR Trading Journal: A record-keeping system where traders document ATR-based trades, allowing for performance analysis and improvement.
ATR Timeframe: The specific time frame or chart interval used for ATR calculations, such as daily, hourly, or weekly.
ATR Trend Strength: Using the ATR to assess the strength of an existing trend, helping traders decide whether to enter, exit, or hold a position.
ATR Breakout Retest: A trading strategy that involves entering a trade after a breakout and waiting for a retest of the breakout level before committing further.
ATR Envelope: A trading tool that plots multiple ATR lines above and below the price chart to help identify potential reversals or trends.
ATR Support and Resistance: Using ATR levels as dynamic support and resistance zones to guide trading decisions.
ATR Trend Reversal Confirmation: A strategy that combines ATR with other indicators to confirm potential trend reversals before taking action.
ATR Histogram: A graphical representation of the difference between two ATR values, providing insight into volatility changes.
ATR Overextension: Identifying situations where the ATR indicates extreme market conditions, potentially leading to reversals.
ATR Crossover: A signal generated when two ATR lines cross each other, indicating a change in volatility or trend direction.
ATR Range Break: A trading strategy that involves entering a trade when the price breaks above or below a predetermined ATR range.
ATR Scalping: A short-term trading style that seeks to profit from small price movements using ATR-based entry and exit signals.
ATR Breakout Gap: A gap in price that occurs when the ATR-based breakout level is significantly higher or lower than the previous closing price.
ATR Reversal Pattern: Recognizing chart patterns combined with ATR signals to identify potential trend reversals.
ATR Swing High and Low: Identifying swing highs and lows using ATR values to spot potential turning points in the market.
ATR Volatility Stop: A stop-loss technique that adjusts based on changes in ATR values, aiming to protect profits during volatile periods.
ATR Position Exit: A strategy for determining when to exit a trade based on ATR conditions, aiming to capture maximum profit or minimize losses.

Average True Range Trading Strategy (Best ATR Indicator, Settings and System) – VIDEO

Key takeaways