Average True Range (ATR) - An Indispensable Tool

Average True Range is an indispensable tool for designers of good trading systems. It is truly a workhorse among technical indicators. Every systems trader should be familiar with ATR and its many useful functions. It has numerous applications including use in setups, entries, stops and profit taking. It is even a valuable aid in money management. The following is a brief explanation of how ATR is calculated and a few simple examples of the many ways that ATR can be used to design profitable trading systems. How to calculate Average True Range (ATR):

• Range: This is simply the difference between the high point and the low point of any bar.
• True Range: This is the GREATEST of the following:
  1. The distance from today's high to today's low
  2. The distance from yesterday's close to today's high, or
  3. The distance from yesterday's close to today's low

True range is different from range whenever there is a gap in prices from one bar to the next. Average True Range is simply the true range averaged over a number of bars of data. To make ATR adaptive to recent changes in volatility, use a short average (2 to 10 bars). To make the ATR reflective of "normal" volatility use 20 to 50 bars or more.

Characteristics and benefits of ATR

ATR is a truly adaptive and universal measure of market price movement. Here is an example that might help illustrate the importance of these characteristics:

If we were to measure the average price movement of Corn over a two day period and express this in dollars it might be a figure of about $500.00. If we were to measure the average price movement of a Yen contract it would probably be about $2,000 or more. If we were building a system where we wanted to use the set appropriate stop losses in Corn and Yen we would be looking at two very different stop levels because of the difference in the volatility (in dollars). We might want to use a $750 stop loss in Corn and a $3,000 stop loss in Yen. If we were building one system that would be applied identically to both of these markets it would be very difficult to have one stop expressed in dollars that would be applicable to both markets. The $750 Corn stop would be too close when trading Yen and the $3,000 Yen stop would be too far away when trading Corn. However, let's assume that, using the information in the example above, the ATR of Corn over a two day period is $500 and the ATR of Yen over the same period is $2,000. If we were to use a stop expressed as 1.5 ATRs we could use the same formula for both markets. The Corn stop would be $750 and the Yen stop would be $3,000.

Now lets assume that the market conditions change so that Corn becomes extremely volatile and moves $1,000 over a two day period and Yen gets very quiet and now moves only $1,000 over a two day period. If we were still using our stops as originally expressed in dollars we would still have a $750 stop in Corn (much too close now) and a $3,000 stop in Yen (much too far away now). However, our stop expressed in units of ATR would adapt to the changes and our new ATR stops of 1.5 ATRs would automatically change our stops to $1500 for Corn and $1500 for Yen. The ATR stops would automatically adjust to the changes in the market without any change in the original formula. Our new stop is 1.5 ATRs the same as always.

The value of having ATR as a universal and adaptive measure of market volatility can not be overstated.

ATR is an invaluable tool in building systems that are robust (this means they are likely to work in the future) and that can be applied to many markets without modification. Using ATR you might be able to build a system for Corn that might actually work in Yen without the slightest modification. But perhaps more importantly, you can build a system using ATR that works well in Corn over your historical data and that is also likely to work just as well in the future even if the nature of the Corn data changes dramatically.

In this article we will show some specific examples of how using ATR can help to make our systems more robust.

First lets look at a simple buy only system for Corn without using ATR. Here are the rules:

1. Buy Corn whenever it rises 4 cents per bushel from the opening price.
2. Take a profit whenever the profit reaches 18 cents per bushel.
3. Take a loss whenever the loss reaches 6 cents per bushel.

Now lets build the same system using ATR. (Assume that the 20 day ATR is 6 cents).

1. Buy when the price rises 0.666 ATRs from the open.
2. Take a profit when the profit reaches 3 ATRs.
3. Take a loss whenever the loss reaches 1 ATR.

We have the original system and a modified version that has substituted ATR for the important variables. The two systems appear to be almost identical at this point. They both will enter and exit at the same prices. Now let's assume that the market conditions change and the Corn market becomes twice as volatile so that the ATR is now 12 cents per day instead of 6 cents. Here is a comparison of the original system and the ATR system:

1. The original entry of 4 cents per bushel from the open is now too sensitive. It will generate too many entry signals since the daily range is now 12 cents instead of only six cents. However, the entry expressed as 0.666 ATRs will adjust automatically and will now require the price to move 8 cents per bushel to enter. The frequency and reliability of our entries remains the same as before.
2. The original profit objective of 18 cents per bushel is much too close for a market that is now moving 12 cents per day. As a result the profits will be taken too quickly and our original system will be missing many opportunities to make much bigger profits than usual. However the profit target expressed as 3 ATRs has automatically expanded the profit objective per trade to 36 cents per bushel. Significantly larger profits are now being realized by the ATR system as a result of the increased volatility.
3. The original stop loss of 6 cents per bushel will now be hit frequently in a market that is moving 12 cents per day. If you combine these frequent stop loss exits with the overly frequent entries being generated, you have a classic whipsaw situation and we can expect to encounter a severe string of losses. Our original system is now failing because the market conditions have changed. We need to fix it or abandon it in a hurry.

However lets look at our ATR version of the system. The stop loss expressed as 1 ATR now sets our stop farther away at 12 cents so it isn't being hit any more frequently than before. We continue to have the same percentage of winning trades only the winning trades are much larger than before thanks to an increased profit objective. Our ATR system has a nice series of unusually large winning trades and is currently making a new equity peak. The ATR system now looks better than ever.

In our example, the proper application of ATR has made the difference between success and failure.

More from Stock & Commodity Futures Trading

» Using Average True Range (ATR) in Entry Logic
» Begin Right or Making Money?
» Donchian's 20 Trading Guides
» How to Set Stop Points
» Market Timing
» Portfolio Heat
» Protecting Big Profit
» Richard Rhodes' Trading Rules
» Risk - Your Only Managable Variable
» Trading Guidelines by Ed Seykota
» more

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