The Average True Range (ATR) is a volatility indicator developed by J. Welles Wilder Jr. Unlike most indicators that measure price direction, ATR measures how much an asset typically moves, regardless of direction. This makes it invaluable for position sizing, setting stop losses, and understanding market conditions.
What is ATR?
ATR measures the average range of price movement over a specified period, accounting for any gaps between sessions. It tells you how volatile an asset is in absolute terms (dollars or points, not percentages).
Simple concept: ATR answers the question "How much does this stock typically move?" If a stock has an ATR of $2, you can expect it to move about $2 from its high to low on an average day.
How ATR is Calculated
ATR uses the concept of True Range, which accounts for gaps:
True Range is the greatest of:
- Current High minus Current Low
- Absolute value of Current High minus Previous Close
- Absolute value of Current Low minus Previous Close
ATR is then the moving average of True Range over a specified period (typically 14 periods).
Why True Range Matters
If a stock closes at $100 and gaps up to open at $105, with a high of $107 and low of $104:
Regular range (High - Low) = $3
True Range = $107 - $100 = $7
True Range captures the full extent of the move including the gap.
How to Use ATR
1. Setting Stop Losses
ATR helps you set stop losses that account for normal market volatility. Using ATR-based stops prevents getting stopped out by normal price fluctuations.
- Conservative: 1x ATR from entry
- Standard: 1.5x ATR from entry
- Wide: 2x ATR from entry
ATR Stop Loss Example
Stock price: $50, ATR(14): $2
You buy at $50 with a 1.5x ATR stop.
Stop loss = $50 - (1.5 x $2) = $47
This stop gives the trade room to breathe through normal volatility.
2. Position Sizing
ATR enables volatility-adjusted position sizing. You risk a fixed dollar amount regardless of the stock's volatility.
ATR Position Sizing
Account: $100,000, Risk per trade: 1% ($1,000)
Stock A: $100, ATR = $5 (5% volatility)
Stock B: $50, ATR = $1 (2% volatility)
Using 2x ATR stop:
Stock A position = $1,000 / $10 = 100 shares
Stock B position = $1,000 / $2 = 500 shares
Both trades risk the same dollar amount.
3. Volatility Assessment
ATR helps you understand current market conditions:
- Rising ATR: Increasing volatility, potentially larger moves ahead
- Falling ATR: Decreasing volatility, consolidation likely
- ATR spike: Major event or breakout occurring
ATR is Not Directional
A rising ATR does not tell you which direction price will move, only that larger moves are expected. Do not use ATR alone to determine trade direction.
ATR Trading Strategies
Volatility Breakout Strategy
- Identify periods of low ATR (consolidation)
- Watch for ATR to start rising (volatility expansion)
- Trade the breakout direction when ATR expands
- Use ATR for stop loss placement
Chandelier Exit
The Chandelier Exit is a trailing stop based on ATR:
- For longs: Highest high minus (3 x ATR)
- For shorts: Lowest low plus (3 x ATR)
- The stop trails behind the trend
- Adjusts automatically for volatility
ATR Channel Strategy
- Plot moving average of price
- Add bands at +/- 2x ATR from the moving average
- Price touching upper band may indicate overbought
- Price touching lower band may indicate oversold
ATR Settings
- 14 period: Standard setting, good balance
- 7 period: More responsive, better for short-term trading
- 21 period: Smoother, better for position trading
The best setting depends on your trading timeframe and style.
Comparing Volatility Across Assets
Since ATR is measured in absolute terms, comparing ATR directly between different-priced assets is not meaningful. Use ATR percentage instead:
- ATR Percentage = (ATR / Price) x 100
ATR Percentage Comparison
Stock A: $200 price, $6 ATR = 3% ATR
Stock B: $20 price, $1 ATR = 5% ATR
Stock B is more volatile even though its ATR is smaller.
ATR in Different Market Conditions
High ATR Markets
- Wider stop losses needed
- Smaller position sizes to manage risk
- Greater profit potential but also greater risk
- More frequent price targets hit
Low ATR Markets
- Tighter stop losses possible
- Larger position sizes may be appropriate
- Slower profit development
- Breakout potential building
Limitations of ATR
- Does not indicate price direction
- Based on historical data - future volatility may differ
- Cannot identify trend strength
- May lag during sudden volatility spikes
- Absolute values not comparable across different assets
Best Practices for ATR
- Always use ATR-based stops rather than fixed dollar/percentage stops
- Adjust position size based on ATR for consistent risk management
- Monitor ATR trends to anticipate volatility changes
- Combine ATR with directional indicators for complete analysis
- Recalculate position sizes when ATR changes significantly
- Use ATR percentage for comparing volatility across assets
Track Your ATR-Based Trades
Pro Trader Dashboard helps you analyze your risk management and position sizing effectiveness across different volatility conditions.
Summary
The Average True Range is an essential volatility indicator that measures how much an asset typically moves. Its primary uses are setting stop losses that account for normal volatility, position sizing for consistent risk management, and assessing market volatility conditions. Remember that ATR does not indicate direction, so always combine it with other indicators. By using ATR for stop losses and position sizing, you create a more systematic and risk-aware trading approach.
Learn more: Trading Volatile Markets and Creating a Trading Plan.