Average True Range Definition
A unit measurement of volatility in the price action of a financial instrument such as a stock, commodity, or future etc. The average true range is the measurement of volatility given a specific “range” of time or period.
For example: ATR(20) would mean you are measuring a stock’s average volatility in a period of the 20 days. The parameter 20 for range is set by the user of this technical analysis indicator.
How To Use Average True Range Indicator – ATR
The average true range ( ATR) is plotted on the stock chart below the main chart. We can see that at the market close, Priceline.com closed at $711 and the ATR (20) below is 19.33. The ATR(20) states that in the volatility is 19.33 points is a period of 20 days. At this specific point in time we can then speculate that in the future the price action will move an average of $19.33 points in the coming days.
Why is important? In plain English: This tells you how bumpy the ride will be. A hot stock will typically move in an uptrend with about two times ATR (20) volatility. Depending on how large your trade size is, that could be a huge fluctuation in your account balance. Your stomach might not be able to handle the action. By understanding ATR and how a stock behaves, you can accurately adjust your position size to keep your risk parameters consistently low. As time goes on volatility and risk change. The fluid nature of volatility requires that you adjust stops accordingly, and consistently monitor the risk factor.
Giving the stock room to move: When a stock is in a trend like the chart above, there are no clearly defined support and resistance lines in which you can set a stop or signal the exit of a trade. Drawing trendlines can prove to be unreliable at times, so you must have a definite set price to exit your position. Understanding volatility using the Average True Range indicator can serve to identify how much degrees of freedom that is normal activity without getting prematurely stopped out of a huge trend.
The Fine Balance: Trading too large will put you out of business, trading too small, you will never make any money. Understanding the Average True Range will enable you to strike the perfect balance in deciding how large of a trade to make. Consistency in money management is what leads to success in trading the markets.
Buy More as the Price Goes Up: This is known as pyramiding. After a stock breaks into new highs and you start to show a profit, your risk becomes lower, therefore you can buy more which increases your profit potential. Again, you must strike the right balance of buying just enough shares. The best and legendary traders like Jesse Livermore made their millions by pyramiding their positions. As soon as they were profitable, they put those profits right back into the market. The average true range gives you an expected price movement and by calculating the how many shares to purchase you can clearly define risk and reward.