The Average True Range (ATR), developed by J. Welles Wilder, is a technical analysis indicator that measures the average volatility of the underlying asset. It was first introduced in the book "New concepts in technical trading systems" and was initially used for trading commodities. However, the indicator is just as useful for stocks or etfs. To do so, it calculates the average of the True Range over a predetermined period. Typically, the ATR is calculated over 14 periods. But those more interested in more recent volatility can reduce the number of periods taken into account. Conversely, those who want to measure volatility over a longer period will have to withhold a higher number.
As with other typical volatility indicators such as the Bollinger Bands and the Keltner Channels, the Average True Range Indicator will indicate when volatility is high or low, with the likelihood of a trend reversal increasing if the ATR rises sharply (high volatility). The lower the ATR value the calmer the price movements are.
Please note that the indicator does not reflect the price direction, a rising ATR is only an indication of increasing volatility, which will manifest itself in both rising and falling prices.
from left to right: ATR(14) - ATR(5) - ATR(22)
The main advantage of the ATR indicator is that it also takes into account the 'missing volatility' created by any gaps between the daily ranges. To be clear, this indicator does not serve to determine/confirm any direction of the price or to show specific buy or sell moments. This indicator is however very suitable to determine the stoploss, taking into account the applicable volatility.
ATR = (Previous ATR * (n - 1) + TR) / n
To properly understand the concept of ATR, we must first take a moment to consider the concept of True Range. This is defined as 'the greater of one of the following':
Absolute values are used to ensure positive numbers. Thus, all three methods measure the distance between two price levels. The 'True Range' always withholds the method whose result gives the greatest distance.
By default, the ATR indicator is usually set to 14 or 22 periods, which can be days, weeks but also intraday time frames such as 1 hour or 5 minutes.
For the first period of the total range over which the ATR average is calculated, the highest and lowest price of that first period will always be retained. This is so because obviously there must be a beginning. Moreover, the very first 14-day ATR period will be based on the average of the daily True Range values of the last 14 days.
Only from day 15 onwards will the data be smoothed by including the ATR value of the previous period.
A higher ATR value (1) is usually the result of a rising or falling underlying value while a lower ATR (2) is a sign that the price movement is rather calm.
An ATR that rises sharply in a short time (3) is a sign that the momentum with which the price rises or falls is very aggressive. This is characterized by the presence of gaps between trading periods.
An ATR value which drops quickly (4) indicates that the momentum has dropped very abruptly.
An ATR which moves sideways (5) indicates little movement, the price quietly flows on within a more or less defined range.
If we calculate twice the ATR as the minimum distance we get to 1.75*2= 3.5. So a stoploss at 2 ATR from the entry price ($151.33) would equate to $147.83 (lower purple horizontal line). And even with an ATR distance of only 1.5 times the ATR value, this would mean that the initial stoploss would be at $148.7.
In that case neither stop would have been hit on the decline after the initial breakout because the post-breakout low was at $148.86. In the case of Agilent Technologies, that makes a big difference when we consider the further price movement....
TIP: ChartMill offers the ability to enter a trailing stop based on an ATR value to protect your open position.
The chart below shows an example of such a trailing ATR stop at a distance of 3 ATR. The stoploss can only increase but never decrease, thus securing a larger portion of the profit each time.
Read more in this article on the ATR-based stop