The Average True Range (ATR) is one of the most important indicators in a trader's toolkit, yet it is often misunderstood. Developed by J. Welles Wilder Jr. in 1978, ATR does not predict price direction but instead measures market volatility. Understanding volatility is crucial for setting proper stop losses, sizing positions, and identifying trading opportunities. This guide will teach you everything you need to know about ATR.
What is Average True Range?
ATR measures the average price movement over a specified period. Unlike other indicators that try to predict where price is going, ATR tells you how much price typically moves. A high ATR means the market is volatile with large price swings. A low ATR means the market is calm with smaller price movements.
The simple version: ATR tells you how much a stock typically moves in a day (or whatever timeframe you are using). If a stock has an ATR of $2, you can expect it to move about $2 per day on average. This helps you set realistic targets and stop losses.
Understanding True Range
Before we can calculate the Average True Range, we need to understand True Range. True Range accounts for gaps between trading sessions and is calculated as the greatest of:
- Current High minus Current Low
- Absolute value of Current High minus Previous Close
- Absolute value of Current Low minus Previous Close
True Range Calculation Example
Yesterday's close: $50. Today's high: $53, low: $48
- Method 1: $53 - $48 = $5
- Method 2: |$53 - $50| = $3
- Method 3: |$48 - $50| = $2
- True Range = $5 (the largest value)
If the stock had gapped up and opened at $52, method 2 would have captured that additional movement.
Calculating ATR
ATR is simply a moving average of the True Range values. The standard setting uses 14 periods. Wilder originally used a specific smoothing method:
Current ATR = ((Prior ATR x 13) + Current TR) / 14
Many platforms use a simple moving average instead, which gives similar results. The key is consistency in your approach.
Interpreting ATR Values
ATR values are in the same units as price, making interpretation straightforward:
- A $100 stock with ATR of $3 means it moves about $3 (3%) per day
- A $100 stock with ATR of $8 means it moves about $8 (8%) per day
- The second stock is more volatile and requires wider stops
To compare volatility across different priced stocks, divide ATR by the stock price to get a percentage. This is sometimes called ATR%.
Practical Applications of ATR
1. Setting Stop Losses
ATR-based stops adapt to market volatility automatically. The most common approach is using a multiple of ATR:
- Tight stop: 1 x ATR below entry for short-term trades
- Standard stop: 2 x ATR below entry for swing trades
- Wide stop: 3 x ATR below entry for position trades
ATR Stop Loss Example
You buy stock XYZ at $50. The 14-day ATR is $1.50.
- Using 2x ATR stop: $50 - ($1.50 x 2) = $47
- Your stop loss is placed at $47
- This gives the trade room to breathe within normal volatility
- If volatility increases, you can adjust your stop accordingly
2. Position Sizing
ATR helps you size positions to risk a consistent dollar amount:
- Decide how much you want to risk per trade (e.g., $500)
- Calculate your ATR-based stop distance (e.g., 2 x ATR = $3)
- Divide risk by stop distance: $500 / $3 = 166 shares
This approach automatically reduces position size in volatile markets and increases it in calm markets.
3. Identifying Breakouts
Expanding ATR often accompanies significant breakouts:
- Low ATR suggests consolidation and potential energy building
- Sudden ATR expansion can confirm a breakout is real
- Breakouts on low ATR are more likely to fail
4. Trailing Stops
ATR works excellently for trailing stops that adapt to volatility:
- Chandelier Exit: Highest high minus 3 x ATR
- As price moves up, the trailing stop follows
- The stop never moves down, only up
- Exit when price closes below the trailing stop
ATR and Market Conditions
ATR behavior tells you about overall market conditions:
- Rising ATR: Volatility is increasing. Markets are becoming more active. Often seen during trend beginnings or major news events.
- Falling ATR: Volatility is decreasing. Markets are calming down. Often seen during consolidation or before breakouts.
- Extremely low ATR: Market is very quiet. A volatility expansion is likely coming.
- Extremely high ATR: Market is very volatile. Could signal panic or exhaustion.
ATR Settings and Customization
The default 14-period ATR works well for most situations, but you can adjust:
- Shorter periods (7-10): More responsive to recent volatility changes. Better for short-term trading.
- Standard period (14): Balanced between responsiveness and smoothness. Good all-around setting.
- Longer periods (20-30): Smoother, less reactive to short-term spikes. Better for longer-term analysis.
Common ATR Strategies
Volatility Breakout Strategy
- Wait for ATR to reach historically low levels (compression)
- Identify a tight price range or consolidation pattern
- Enter when price breaks out with expanding ATR
- Set stop at 1.5 x ATR below entry
- Target at least 2 x ATR from entry
ATR Channel Strategy
- Plot a moving average of price (e.g., 20-period SMA)
- Add upper band: MA + (2 x ATR)
- Add lower band: MA - (2 x ATR)
- Buy when price touches lower band in uptrend
- Sell when price touches upper band in downtrend
ATR vs Other Volatility Measures
How does ATR compare to other volatility indicators?
- ATR vs Bollinger Bands: Both measure volatility, but Bollinger Bands also show price levels while ATR is purely a volatility number.
- ATR vs Standard Deviation: ATR uses True Range (accounts for gaps) while standard deviation uses closing prices only.
- ATR vs VIX: VIX measures implied volatility for options. ATR measures historical price volatility.
Common Mistakes to Avoid
- Using ATR as a directional indicator: ATR does not tell you which way price will move, only how much it might move.
- Ignoring ATR changes: A stop that was appropriate last week may be too tight if volatility has increased.
- Setting stops too tight: Stops inside 1 x ATR will often get triggered by normal market noise.
- Not adjusting for different instruments: What is "high" or "low" ATR varies by market. Always compare to historical ATR for that specific instrument.
Optimize Your Risk Management
Pro Trader Dashboard helps you track your trades and analyze your risk management effectiveness. See how your ATR-based stops perform and refine your approach over time.
Summary
The Average True Range is an essential tool for understanding market volatility. While it does not predict price direction, ATR is invaluable for setting proper stop losses, sizing positions correctly, and identifying when markets are likely to make big moves. By incorporating ATR into your trading, you can make more informed decisions about risk management and improve your overall trading results.
Ready to learn more about technical indicators? Check out our guide on the Parabolic SAR or explore Keltner Channels.