Managing volatility with the Average True Range Indicator
In any trading activity that is done there needs to be extensive risk management planning done in order for the trader to preserve as much of their capital as they can. While there may be plenty of ways in which traders determine where they will place their stop loss orders there is a particular indicator that can regularly be applied for just this purpose – the Average True Range. This is a volatility based indicator that helps the trader avoid placing their stop loss orders too close to the market and getting their position closed out only to have the price reverse and then carry on in the direction they originally anticipated.
The Average True Range (ATR) is another in the long list of indicators created by renowned technician J. Welles Wilder. Like the measurement of standard deviation it is an indicator that is made to measure volatility but does it in a different way because the ATR looks at recent price movements and then draws them together into a single value. You don't need to know how to calculate the ATR but you need to understand the calculation in order to best understand how to apply it.
The first thing that goes into this calculation is the true range. Quite simply this is the greatest of the following:
• The current bar/candles high minus the current bar/candles low;
• The difference between the current candle/bar high and the close of the previous bar/candle; OR
• The difference between the current candle/bar low and the close of the of the prior bar/candle.
Whichever of these values is the largest becomes the true range for that period. In order to become an ATR you need to start averaging the true range over a number of periods – in the same way you would work out a moving average on prices. The standard number of periods over which the ATR is calculated is 14. The trader can elect to modify this figure if they choose but for the most part it's preferable to work with the default figures because otherwise the trader risks curve fitting the indicator inappropriately. Instead, the trader can apply multiples of the ATR which still allows a great deal of flexibility.
An area of common confusion with this indicator applies when a multiple of the value of the ATR is applied. In many references you may see it recommended to use a 1.5 or 2 ATR stop loss. This doesn't mean that you calculate the ATR over 1.5 or 2 periods but instead means that you multiply the 14 period ATR by this value. If you like to backtest your strategies (particularly if you are using software) the ATR can be very effective as your stop loss method and to help you work out your position sizes (based on methods such as fixed percentage models).
The most common way in which the ATR and its multiples is applied is as a stop loss placement tool. This can serve 2 very important purposes for the trader. The first of these is to be used so that you are less likely to get closed out simply because of ordinary market/stock price volatility. If the trader places their stops too close to the market price they may get closed out just because of normal short term oscillations in price. Sometimes traders will feel that the closer the place their stop to the market then the less risk that they will be exposed – whilst there may be an element of truth in this it will likely prove to be totally ineffective if they place their stop within the value of the ATR.
The second benefit of this type of method is that it's not reliant on finding things like support or resistance lines as a means of placing your stop loss order in sensible places because now the trader will be placing them based on recent volatility. This is the reason why multiples of the ATR are applied so as to add extra distance from the current price and reduce the probability of getting closed out of the position due to standard market volatility. This doesn't mean that traders can't apply methods like support and resistance but even if they do its worth being mindful of what the ATR saying about likely volatility behaviour of the instrument.
Traders may also be able to use multiples of the ATR as a value for their trailing stop loss. The main thing here though is that you only move your stop loss in the same direction in which you want your trade to go. Another way of saying this is that movement of stops should only reduce risk and never increase it. In addition the trader can use the ATR as a means of acting as a filter for breakout trades. Imagine that you were trading a range (rectangle formation) and were looking for a breakout but wanted to reduce your chances of facing a whipsaw trade. You may wait for the price to exceed the breakout point by a tested ATR multiple before entering the trade. Again this type of method uses the ATR's primary role of avoiding entering or exiting trades simply because of market volatility.
What you can see now is a simple indicator that can easily be applied to a range of different trading situations such as stop loss placement and breakout trading. In any case this indicator should give traders a better understanding and appreciation of volatility on individual instruments that they may trade and adjust their activity accordingly. A great outcome is that the trader avoids being closed out of trades due to nothing more than market volatility which in many cases can be anticipated by using indicators such as the ATR.