This article will provide informative descriptions of what the ATR indicator is and what trailing means. In addition, it will go over how one can use this indicator as a trailing stop.
What is it?
The ‘average true range’ (ATR) indicator is a popular technical analysis indicator. Its main objective is to measure the volatility of the market. Its method of conducting this is by breaking down the entire price range of an asset for that specific period. Overall, the core purpose of the ATR is to act as a measure of volatility. It was introduced by market technician, J. Welles Wilder Jr., in his book, “New Concepts in Technical Trading Systems.”
The ATR indicator moves up and down as the price of an asset moves, becoming either larger or smaller. The calculation of a new ATR reading is done so as every time cycle passes by. In the case of a one-minute chart, the calculation of a new ATR reading is every minute. On a daily chart, the calculation is every day. Do you see a pattern with the chart and the calculation?
The plotting of each and every one of these readings are primarily for the formation of a continuous line. Therefore, traders are able to see how volatility changes over time.
The true range indicator is taken as the greatest of the following:
- Current high less the current low
- The absolute value pertaining to the current high less the previous close
- The absolute value pertaining to the current low less the previous close
The average true range becomes a moving average of the true ranges. Generally speaking, it uses 14 days.
One more important thing to note is that the ATR indicator is not a trending indicator. Many believe this to be true, but that is a common misconception.
Where did it come from?
During his development of the indicators, Wilder was simultaneously looking at the commodity markets. He would come to the realization that merely looking at the day’s range was too simplistic. Especially in regards to functioning as a measure of volatility. This is largely due to the way in which commodities frequently go limit up or limit down. Or, perhaps, a gap in price from the close of the previous day to the new opening.
This would essentially mean that there is one specific way to adequately reflect the true volatility of the market. Wilder would need to take the previous day’s close, as well as the current high and low, into consideration. Going forward with this realization, he went on to define the true range as being the greatest out of these three values:
- The total distance between the current high and the current low
- The distance that exists between the previous close and the current high
- The distance that exists between the previous close and the current low
Wilder then made a proposition. That is to take an average of this value throughout the course of several days. Doing so will provide a worthwhile representation of volatility. Logically enough, he would call this the ‘average true range’, effectively creating the indicator we know and love.
So, we know when calculations occur, but how would one calculate ATR? Well, the first step is to find a series of true range values for security. For the most part, the price range of an asset for a given trading day is its high minus its low. At the same time, the true range is a lot more encompassing. The formula is the following equation:
TR = Max [(H – L), Abs (H – Cp), Abs (L – Cp)]
ATR = (1/n) (n)∑(i=1) TRi
For context, TRi means a particular term range and n means the time period employed.
Traders can sometimes use shorter periods instead of 14 days in order to generate more trading signals. Longer periods typically have a higher probability of generating a lesser amount of trading signals. For example, suppose that a short-term trader only wants to analyze a stock’s volatility during a period of five trading days. In this particular case, the trader could calculate the five-day ATR.
Now, let’s assume that the arrangement of the historical price data is in reverse chronological order. The trader will find the maximum of the absolute value of the current high minus the current low. Moreover, the absolute value of the current high minus the previous close and the absolute value of the current low minus the previous close. These true range calculations are for the five most recent trading days. Afterward, they are averaged to determine the first value of the five-day ATR.
Helping with decision-making in trading
Day traders can make great use of the information from the ATR indicator on how much an asset typically moves in a certain period. They can apply it to the purposes of plotting profit targets and determining whether they should attempt a trade.
Let’s imagine that a stock moves $1 per day on a regular basis. There is no outstanding news out, however, the stock is already increasing $1.20 on the day. The trading range (i.e. high minus low) ends up at $1.35. The price made a prior move 35% more than the average. At this point, you are now getting a buy signal from a strategy. The buy signal is valid but consider also that the price is already moving significantly more than average.
In this sense, betting that the price will continue moving upward and expanding the range even further is probably not a good decision. The trade will go against the odds.
Because the price is already up considerably and is moving more than the average, then the price will likely fall. Furthermore, it will remain within the price range that was already established. Admittedly, buying as soon as the price is close to the top of the daily range – as well as the range is surpassing the average – is not prudent. Be that as it may, selling or shorting is an ideal option; that is, assuming a valid sell signal occurs.
Let’s look at the situation from earlier. In that case, you should not sell or short purely because the price is moving up. Likewise, you shouldn’t do it if the daily range is larger than usual. The ATR will confirm the trade only if a valid sell signal occurs, drawing from your specific strategy.
The exact opposite could also occur in the event of the price suddenly dropping. What’s more, if it is trading near the low of the day and the day’s price range is much larger than usual. If this happens, and if a strategy generates a sell signal, you should do one of two things. You can ignore it or you can take it with an extreme amount of caution.
True, the price may continue to decrease, but it is against the odds. There is a high chance of the price moving upward and remaining between the daily high and low already settled. Keep an eye out for a sell signal that draws its foundation from your strategy.
If nothing else, you should take time to review historical ATR readings, too. It’s likely that the stock is trading beyond the current ATR. However, the movement may actually turn out to be quite normal according to the stock’s history.
First and foremost, we need to define what a ‘stop order’ is, as it will make understanding ‘trailing’ easier. A stop order (also known as a ‘stop’) is an order that pertains to buying or selling a security. Specifically, when its price moves past a particular point. When this happens, it guarantees a higher probability of achieving a predetermined entry or exit price. Moreover, it will limit the investor’s loss or locking in a profit. As soon as the price crosses the entry/exit point, the stop order will promptly become a market order.
Now, a ‘trailing’ stop is basically a modification of the conventional stop order. It can be set at a specific percentage or dollar amount away from the current market price of a security. In the case of a long position, an investor places a trailing stop loss below the current market price. On the other hand, for a short position, an investor will place the trailing stop above the current market price.
The design of a trailing stop allows it to protect gains by way of enabling a trade to remain open. Moreover, to continue to make a profit so long as the price is moving in favor of the investor. The order will close the trade if the price suddenly changes direction by a specific percentage or dollar amount.
Most of the time, the placement of a trailing stop is at the same time as the placement of the initial trade. However, the placement may also occur after the trade.
How it works
Trailing using the ATR indicator stops will only move in one direction. This mostly due to the fact that their inherent design permits them to lock in profit or limit losses. If there is an addition of a 10% trailing stop loss to a long position, then there will be an issuance of a sell trade. That is, if the price should suddenly drop 10% from its peak price following the purchase. The trailing stop will only move upward as soon as there is an establishment of a brand new peak. Once the trailing stop effectively moves up, it is unable to move back down.
A trailing stop is comparatively more flexible than a fixed stop-loss order. This is because it automatically tracks the direction of the stock’s price. Moreover, there is no requirement to manually reset it like the fixed stop-loss.
Investors are able to use trailing stops in any asset class. It mostly depends on if the broker provides that order type for the market that you are trading. Trailing stops can be set as one of two types of orders: limit or market.
Trading with these stop orders
There is a special method of using a trailing stop successfully. The key is to set it at a level that is in the middle of wide and tight. It is neither too tight nor too wide, and it is important to maintain its spot in the center. Placing a trailing stop loss that’s too tight could mean that normal daily market movement could trigger the trailing stop. Thus, the trade will have no room at all to move in the trader’s direction.
A stop-loss that leans towards being too tight will often result in a losing trade. A small one, mind you, but a loss nonetheless. Normal market movements typically won’t trigger a trailing stop that is too large. However, it essentially means that the trader is taking on the risk of needlessly large losses. Alternatively, they risk giving up more profit than they really need to.
Trailing stops are capable of locking in a profit and limiting losses. What’s difficult, however, is establishing the ideal trailing stop distance. The truth of the matter is there is no ideal distance. The reason for this being that markets and the way in which stocks move are constantly changing. In spite of this, trailing stops are still effective tools. Generally speaking, every exit method has its advantages and disadvantages, so this is nothing new.
ATR Indicator and Trailing, together at last
ATR trailing stops are a technique that utilizes the principles behind the average true range. This, as you may recall, is a measurement of the degree of price volatility. What the trailing stops do is they use these principles as a way to establish trailing stop-losses. The core idea here is that ATR provides a guide to the average volatility of price movements over a specific time period. In turn, it makes it so much easier to be precise about where to set the stop-loss. In other words, ATR trailing stops aid you in holding onto your trades longer.
Of course, you always have the option to use moving averages as a trailing stop. These are handy in that they tighten up with a price. However, the ATR indicator is another ideal method and it is what we are focusing on.
Average true range trailing stops are comparatively more volatile than stops that draw from moving averages. What’s more, they are prone to whipsawing you in and out of positions, with the exception of where there is a strong trend. That is the main reason why using a trend filter is crucial.
ATR trailing stops are much more adaptive to fluctuating market conditions than Percentage Trailing Stops. On the downside, they tend to achieve similar results when you apply them to stocks that were previously filtered for a strong trend. Concerning ATR trailing stops, the average true range is ultimately the true range calculation over a 21-day period average. This number of days is the default.
The ATR indicator calculates your average daily range averaged out over the number of days. For example, a 14-period ATR on a daily chart will be 14 days arranged on the average of that. One big range will smooth out substantially. If, however, you are going into a smaller number, it will be more sensitive to current days. Why? Because it is a much longer period
If you are in a trade and you are running with it, using this stop will ratchet itself up by drawing from the range. You take the ATR and you multiply it by, for example, three. Assume that three times your daily range is a stop. This means that as some things start to get chaotic, it will be wide enough to accommodate that noise. When it begins to consolidate, it will tighten things up a bit because the ATR will start falling depending on the period.
So, in essence, ATR trailing spots lock your gains in as the price moves in your specific direction.
Breaking down the formula
ATR indicator Trailing stops calculations are normally relative to closing price. We touched upon the formula earlier, so let’s dive deeper into it:
- The first thing you need to do is calculate the ATR.
- Next, you will need to multiply the ATR by your selected multiple. Let’s use 3 x ATR as an example.
- In the case of an up-trend, subtract 3 x ATR from the Closing Price. Afterward, plot the result as the stop for the following day.
- Should the price close below the ATR stop, add 3 x ATR to the Closing Price. This will track a short trade.
- Otherwise, proceed to subtract 3 x ATR for each consecutive day up until the price reverses below the ATR stop.
Sign Up For HedgeTrade
If you haven’t had a chance to sign up to the HedgeTrade social trading platform, you can do that right here. We have a market for crypto predictions, where traders can profit from their expertise and novices only pay for correct information. Soon we’ll be adding esports and stock predictions! You can check out our Leaderboard of top traders here.