The Best Way to Use the ATR Trailing Stop Loss Indicator
ATR or Average True Range indicator is another important volatility based indicator. ATR is simply the average of true ranges over the past n periods, true range is the full price range of a period including gaps.
ATR trailing stop loss indicator is used in many trading strategies, before we discuss the application of ATR let us explore more about volatility and true range.
Table of Contents
- Volatility Index & True Range
- ATR Trailing Stop Loss Indicator
- Example of ATR Trailing Stop Loss Indicator
- Key Takeaways
Volatility Index & True Range
Volatility is defined as a price range that has moved over time; however, due to the gaps that affect the range on a particular time period, true range terminology is more appropriate in trading.
True range can be defined as the largest value of following range –
- Distance from today’s high to today’s low
- Distance from yesterday’s close to today’s high
- Distance from yesterday’s close to today’s low
True Range TR = max(high, closeprev) – min(low, closeprev)
For practical purpose and to use the concept of true range in trading, average of true range made per day over the number of days is called Average True Range
Number of days considered to obtain true range depends upon sensitivity of the ATR indicator, for less number of days used Average true range may be too fast to obtain the real or actual true range and volatility, and a large number of days may be too slow to react to changing volatility.
J. Welles Wilder Jr.’s study on the volatility index shows that using a 14-day period to calculate ATR is a good way to get the best possible true range. Also . In most of the trading platform you will find the default setting of ATR to 14
Calculation of Volatility Index
Volatility Index = 13 * Vp + TR1/14
Where Vp = Previous value of volatility index
TR1 = Current value of true range
Calculation of Average True Range
Average True Range ATR is calculated by following formula
Where TRi = True Range (n number of days)
ATR Trailing Stop Loss Indicator
Average true range tracks the volatility associated with price activity. It assists traders in identifying stop loss points because it is a simple moving average of true range. Many traders find it difficult to place meaningful stop loss in a volatile market, especially in current market scenarios where stop loss hunting is a common occurrence it is important for traders to use multiples of ATR to find stop loss points.
To use ATR trailing stop loss indicator following points should be remembered –
- When price volatility increases value of ATR also increases
- During a downtrend if ATR value increases, it signals bearish continuation.
- If ATR value falls during a downtrend, it signals bullish reversal
- Rising ATR in an uptrend is bullish continuation
- Falling ATR in uptrend is bearish indication
- Extreme ATR values frequently indicate a trend reversal.
Example of ATR Trailing Stop Loss Indicator
ATR trailing stop loss indicator can be utilized by following ways –
- Using multiples of ATR to find a meaningful stop point.
- Using historical ATR valleys and peaks to find area of price reversals
- Using 2 standard deviation band along with ATR to place stop loss
Following multiples are used by traders to place stop loss –
- 1 ATR
- 1.5 ATR
- 2 ATR
- 4 ATR
Locational Price Area Method for ATR Trailing Stop Loss
Use support and resistance lines in charts along with ATR to find price reaction at important levels of support and resistance. This way, you can recognize locational volatility at support and resistance levels.
To calculate locational volatility following steps can be followed –
- Find lookback period – how many areas of previous support and resistance to check
- Add ATR values at the levels of support or resistance for the lookback period.
- Divide by number of points considered
- Use this value of ATR with multiples to get the desired ATR trailing stop Loss.
For example, to calculate SL using the ATR trailing stop loss method at the price range breakout shown in the above figure, perform the following steps:
- First we need all touchpoints at resistance level i.e. the lookback period in this case it is three.
- Adding ATR values at those touchpoints of resistance level –
Sum of all ATR’s for lookback period = 36.44+46.71+47.35
- Find locational ATR at the breakout level.
Locational ATR = 130.5 / 3
- For this example we are using multiplication factor of 2 for ATR calculation, hence ATR trailing stop loss would be –
Stop Loss = Locational ATR * Multiple Factor
= 43.5 * 2
In above example meaningful stop loss would 87 points below breakout level
Stop loss Level = 1614 – 87
- ATR helps in measuring the volatility of the market.
- True range is calculated by including gaps, high and lows of price range.
- Increase in price volatility results in higher ATR.
- High or extreme values of ATR gives clues for trend reversal in markets.
- Standard period of ATR is 14, it can be changed according to the fast or slow reacting ATR indicator.
- ATR trailing stop loss indicator can be used in multiple factors like 1, 1.5, 2, 3 , 4
- Locational ATR calculation helps in finding out meaningful stop loss points during range breakouts.
- Bollinger bands, Donchian channels, volatility index and ATR are used by price action traders to take volatility into account for price action trading.
“If you build a system that gives you an entry and exit, tells you how much to bet along the way and adjusts to your current capital and current market volatility at all times, no more analysis is needed.”The Anonymous Trader
Frequently Asked Questions
How to Use ATR indicator?
ATR is best suited for trailing stop loss, adjusting stop loss as per true range save traders from getting stopped out on market noise.
ATR is leading or lagging indicator?
ATR is derived from price movement and directly respond to the price move and hence it is a leading indicator.
What is the best setting for ATR?
14 period setting is considered best for trailing stop loss use of ATR. Taking more than 14 days to measure true range can make ATR indicator slow and less than 14 will provide many false signals , hence the value 14 is optimum for ATR.