Using Volatility as a Measure to Improve Order Placement
An asset’s average daily movement over a specified time period is shown by the volatility indicator known as the true average range (ATR). The indicator can be used to place a stop-loss order and to help day traders determine when they might want to start a trade.
ATR Indicator Analysis
As price changes in an asset get bigger or smaller, the ATR indicator goes up and down. Each period results in a new ATR reading. A new ATR reading is computed and displayed on a one-minute chart every minute. A new ATR is computed each day and plotted on a daily chart. In order to show traders how volatility has changed over time, all of these readings are plotted to form a continuous line.
You must first determine the number of true ranges to calculate the ATR (TRs) manually. The TR is the highest among the following for a particular trading period:
- Lowest recent high minus the most recent close
- less than the prior close, the current low
- current low less than the current high
It makes no difference if the value is positive or negative. The calculation uses the highest absolute value.
Each period’s values are noted, and then an average is calculated. There are typically 14 periods used in the calculation. After completing the initial 14-period ATR, J. Welles Wilder, Jr. used the following formula to smooth the data for subsequent periods:
Current ATR is equal to (Previous ATR x 13) + Current TR) / 14
The Benefits of ATR for Trading Decisions
Day traders can plot profit targets and decide whether to attempt a trade using the information on how much an asset typically moves over a specific period.
Assume a stock has an average daily movement of $1. Despite the lack of any significant news, the stock has already increased by $1.20 today. The trading range is $1.35 (high minus low). You are now receiving a buy signal from a strategy as the price has already moved by 35 percent more than the average. The buy signal might be accurate, but it might not be wise to bet that the price will rise further and widen the range, given how much it has already moved from the average.
The transaction defies the odds
The price is more likely to decline and remain within the already established price range because it has increased significantly and moved more than the average. Selling or shorting is probably a wise move, assuming that a valid sell signal appears once the price is close to the top of the daily range and the range is significantly greater than average. Buying at that point is not advised.
Important: The ATR should not be used as the sole basis for entries and exits. The ATR is a tool that can be used to help filter trades when combined with a general strategy.
As an illustration, in the scenario described above, you shouldn’t sell or go short just because the price has increased and the daily range is wider than usual. The ATR would only aid in trade confirmation if a legitimate sell signal materialized, according to your specific trading strategy.
The opposite might also take place if the price falls and is trading close to the day’s low and the daily price range is wider than usual. In this situation, if a strategy generates a sell signal, you should disregard it or treat it cautiously. Despite the possibility, it is unlikely that the price will keep dropping. It is more likely that the price will increase and continue to trade in the range of the previous day’s high and low. On the basis of your strategy, search for a sell signal.
Additionally, you ought to look over earlier ATR readings. The movement may be quite normal based on the stock’s historical performance, despite the possibility that it is trading outside of the ATR at the moment.
Trends for Day Trading ATR
If you use the ATR on an intraday chart, like a one- or five-minute chart, it will spike higher when the market opens. The ATR rises in the first minute of trading for stocks when the major U.S. exchanges open at 9:30 a.m. ET. This is because volatility is highest at the open, which is also the most volatile time of the day, as shown by the ATR.
The ATR typically declines for the majority of the day following the spike at the open. Other than how much the price is moving on average per minute, the ATR indicator’s oscillations throughout the day don’t reveal much about the market. Day traders can estimate how much the price might change in five or ten minutes using the one-minute ATR in the same way they do with the daily ATR to determine how much an asset moves in a day. This strategy may aid the use of stop-loss orders or profit targets.
Tip: The minimum number of minutes it will typically take for the price to reach the profit target is the product of your expected profit and the ATR.
If the one-minute chart’s ATR is 0.03, then the price is moving at a rate of about three cents per minute. You can anticipate that the price will most likely take at least five minutes to rise by 15 cents if you predict that it will increase and you decide to buy.
Trailing ATR Stop-Loss
If the asset price moves against you, a trailing stop-loss allows you to exit the trade; however, if the price moves in your favor, you can move the stop-loss point. Several day traders use the ATR to determine where to place their trailing stop-loss.
Take a look at the ATR reading right before you place a trade. An easy way to find a reasonable stop-loss level is to multiply the ATR by two. As a result, if you were to buy a stock, you might set a stop-loss at a point twice the ATR below the entry price. A stop-loss would be set if you were shorting a stock at a price that was twice the ATR above the entry price.
Continue lowering the stop-loss to twice the ATR below the price if you are long and the price is moving in your favor. In this case, the stop-loss never moves downward; it always moves upward. When it is moved up, it stays there until it can be moved up again or the trade is closed when the price drops to the trailing stop-loss level, which triggers the position’s closing. The process is the same for short trades, but the stop-loss only moves downward in that situation.
Consider taking a long position at $10 with an ATR of $0.10. A stop-loss order would be placed at $9.80 (2 * $0.10 below $10). The ATR stays at $0.10 while the price increases to $10.20. Now set at $10, the trailing stop-loss. The stop-loss increases to $10.30 when the price rises to $10.50, guaranteeing at least a 30-cent profit on the trade. Until the price reaches the stop-loss level, this will continue.
Most Commonly Asked Questions (FAQs)
What is revealed by the mean true range?
You can get a sense of how much the price might fluctuate by looking at the volatility indicator known as a true average range (ATR). Day traders can use this to decide where to enter and exit trades while combining it with other indicators and strategies.
How much should the average true range indicator be?
There are other successful strategies besides using the standard number 14 with an ATR indicator. Use a smaller number if you want to emphasize the volatility levels of recent times more. In order to take a broader measurement, long-term investors might prefer to use a higher number.