In trading, risk management and position sizing often matter more than simply predicting market direction. The ATR (Average True Range) indicator is a powerful tool to measure market volatility, set dynamic stop losses, and identify breakout opportunities.
1. What Is ATR?
Developed by Welles Wilder in 1978, ATR does not indicate trend direction but measures the average range of price movement over a specified period. A higher ATR means greater volatility; a lower ATR implies quieter markets.
2. How ATR Is Calculated
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True Range (TR):
TR = max(high – low, |high – previous close|, |low – previous close|) -
Average True Range (ATR):
ATR₁ = TR₁
ATRₙ = (ATRₙ₋₁ × (n – 1) + TRₙ) ÷ nCommon setting: n = 14 (ATR is the 14-period moving average of TR)
3. Practical Uses of ATR
3.1 Volatility-Based Stop Losses
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Fixed Multiplier Method:
Stop distance = Current ATR × k (k often between 1.5 and 3)
e.g., ATR = 1.2, k = 2 → stop ≈ 2.4 points -
Channel Stop Method:
Draw an MA ± k×ATR channel; exit when price breaks the lower channel line.
3.2 ATR Breakout Strategy
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A sudden spike in ATR signals increasing volatility and often precedes trend formation.
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Combine with price breakouts for entry signals (e.g., price breaks above recent high).
3.3 Position Sizing
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ATR-based lot sizing: Reduce position size when ATR is high (risk is large); increase when ATR is low.
4. Combining ATR with Other Indicators
| Combination | Purpose | Example Strategy |
|---|---|---|
| Bollinger Bands | Volatility & Overbought/Oversold | ATR↑ + Bands expansion → enter on channel breakout |
| RSI | Overbought/Oversold readings | ATR↑ + RSI<30 → strong volatility & oversold → consider long entry |
| MACD | Trend direction & momentum | ATR↑ + MACD bullish crossover → follow the trend up |
| ADX | Trend strength |
|
5. Case Study: XYZ Stock Daily Chart
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Setup: XYZ consolidates around $50, ATR < 0.8 indicates low volatility.
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Signal: ATR spikes to 1.5 (nearly 2× prior values), price closes above $52.
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Trade Plan:
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Entry: Close price above $52
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Stop Loss: 52 – (2 × ATR) ≈ $49
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Target: Based on resistance level or a 1:2 risk-to-reward ratio (~$56)
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This trade captured the trend’s early phase while ATR-based stop loss effectively controlled risk.
6. Key Takeaways
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Respect volatility: ATR-based stops and position sizing make your trading more robust.
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Confirm with other indicators: ATR is powerful but not foolproof—use it alongside trend, momentum, and overbought/oversold tools.
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Optimize and backtest: Different assets and timeframes may require ATR settings of 10, 14, or 20 periods to suit your strategy.
