How to use Average True Range Indicator for Short-Term Trading?
How to use Average True Range Indicator for Short-Term Trading?
In trading world, there are numerous technical indicators used by highly proficient technicians to find out direction and trend of market and potential buying or selling opportunities with the right level of entry and exit points to make your trade highly profitable at the lowest risk.
So these indicators can be generally classified into 2 major categories- 1. Long term 2. Short term. Here we can consider only shorter duration and that’s why technical indicators used intraday trading or day trading is in high demand. One of the most commonly used indicator in average true range indicator generally known as ATR. Lets discuss about this ATR, its uses, its accuracy, calculation in detail so that novice can easily use it at ease
The average true range (ATR) indicator is a very useful tool for technical analysis developed by J. Welles Wilder Jr. that you can use to measure the volatility of the market or individual underlying security. As a volatility indicator, it measures the strength of the price action of an underlying security for a specific period typically 14 days, that’s called the true range.
To be more precise ATR is more of a volatility indicator rather than a trend or directional. ATR not only considers the closing price difference but also the high-low range and the difference between the closing price and the previous day’s closing price. When you incorporate these components, you can get more insight into the price movement of the underlying security, compared to just using the closing price difference.
The calculation of the average true range might be challenging or complicated for traders, especially those who are novices in the market. For calculation purpose duration is solely depend on time frame you have taken. Some calculated ATR on the basis of daily and weekly while it can be calculated on the basis of intraday and monthly too. However, while plotting the true range period the readings from the continuous line showing the change represents the volatility over that time period.
To find out the ATR value you have to go through the series of true ranges that need to be calculated. So first define a trading period and the actual range or you can say true range is the highest of absolute values computed by the given method-
1. Current high — Current low
Current low — Previous close
Current high — Previous close
Here the average is considered for recorded values of each period using the 14 period time range. This value is the average true range and the 14-period average true range value can be calculated using the procedure stated above. The subsequent 14-period average true ranges can be calculated with the formula given below.
True Range (TR) for Each Period: For each period, calculate the True Range (TR) using the formula given below:
TR = Max (High — Low, |High — Previous Close|, |Low — Previous Close|)
Here, “High” and “Low” signify the highest and lowest prices of the current period, and “Previous Close” refers to the closing price of the previous period. The absolute value (|) ensures positive values.
Average True Range (ATR): Once you have the TR values for your preferred period, calculate the ATR using the formula mentioned below:
ATR = Average (TR for the past n periods)
“n” represents the number of periods you count like 14 days. You can calculate the average manually or through charting platforms that have built-in ATR calculations system.
You can use the ATR to trade with stop-loss orders for the underlying security that has natural fluctuation in price movement. A simple rule of setting the stop loss using the ATR is to multiply the ATR by two to determine a reasonable stop-loss point.
If you are going to take long position in a stock, you can place the stop loss at the level twice the ATR below the entry point and vice versa in case of short selling. Let’s make a predefined formula for stop loss calculation-
SL for buying the Stock: Stop Loss = Entry Price — (ATR * Multiplier)
SL for selling the Stock: Stop Loss = Entry Price + (ATR * Multiplier)
Additionally, you can exit from your trade positions when ATR is trading in the following stop line.
Close your buy positions if ATR stop line triggered below
Close your short positions if ATR stop line triggered above
As discussed above ATR is very usefull in all market conditions coupled with other technical in dicators. Apart from using the entry and exit points, you can use the ATR for various short-term trading strategies. Let’s find out how you can use the ATR for the short term with suitable trading strategies.
When ATR value is high, it gives the signal of potential opportunity as the volatility in the market is high and there could be volatile breakouts or breakdowns. On the other hand, when ATR is low, it suggests the market is likely to consolidate where the trend continuation or reversal is impending. However, combining top best technical indicators to know the precise exit and entry points for short-term trading is important to get better outputs from trading.
One of the best ways of using the ATR in trading is to set the stop loss at the right levels to minimize the risk if the market moves against your expectations. The value of ATR will help you to determine the stop loss below the entry point in long trade positions. While in short selling, the ATR will indicate the right stop loss above the entry point making it easier to exit.
Position sizing is one of the best trading strategies to help you minimize your risk tolerance. In short-term trading, you have enough time and opportunity to adjust your trade positions as per the changing market conditions.
When the market is highly volatile or you can say, when ATR is high you can consider trading with smaller positions to limit your risk exposure. On the other hand, in low market volatility or when ATR you can take risks with large trade positions.