Day Trader's Toolbox Part 3: Average True Range (ATR)

1 de nov. de 2023

Welcome to the final instalment of our Day Trader's Toolbox series, in which we highlight some essential tools and indicators which have the potential to transform your day trading.

Today we lift the lid on the Average True Range or ATR – a simple yet highly effective tool when analysing the price movement of any market. We’ll explain how ATR helps you to view the market through the eyes of a professional trader and we’ll outline the three core uses for ATR in day trading.

I. Understanding ATR:

What is ATR?

Okay, let’s start with the basics: ATR is designed to measure market volatility by calculating the average range between the high and low prices over a specific period.

Without delving into the ATR formula, it's important to understand that this indicator takes price gaps into account. This factor provides traders with an authentic representation of market volatility.

On TradingView, the ATR indicator appears as a line underneath your chart. And whilst it can be calculated on any timeframe, we typically talk about ATR in terms of the daily timeframe – hence ATR will tell us how much we can expect a stock to move up or down in typical trading day.

Daily ATR on Daily Candle Chart

Past performance is not a reliable indicator of future results

Start Seeing Price Movement Like a Seasoned Trader

Have you ever found yourself drawn to the lists of top gainers and losers on stock trading platforms? It's a common fascination for novice traders, as these lists provide quick summaries of what's "hot" on any given day.

However, seasoned traders know that evaluating stock prices solely based on percentage movements is about as practical as a paper umbrella in a rainstorm.

To illustrate this point, consider two stocks, Stock A and Stock B, both opening with a 3% increase. Yet, Stock A typically fluctuates by 3% on an average day, while Stock B usually moves by 1.5%. In this context, Stock B's price movement is far more significant.

This is where ATR comes into play. ATR normalises market price movements, making it a valuable tool for comparing a stock's price changes against its historical performance and its peer group.

So, it's time to shift your perspective. Leave behind the world of percentage-based analysis and adopt ATR to see price movement through the eyes of a professional trader.

II. 3 Ways to Use ATR When Day Trading

1. Profit Targets

Consider this day trading scenario: The market has broken above its previous day's high (PDH), and the price is showing signs of consolidation while staying above VWAP. With these clear signals of strength and insights from your higher timeframe analysis, you decide to go long. Now, the question is, where do you place your profit target?

Answer:

As a day trader, your goal is to capitalise on intraday price movements and avoid holding positions overnight, thereby mitigating overnight risks. This means that setting a structural target, such as the next resistance level, may not be practical.

However, if you incorporate the daily ATR with the current day's low, it provides you with an exceptionally realistic profit target. This target is entirely objective and calibrated to the specific market's current level of volatility.

It's important to note that ATR is an average, so it should be used as a guide rather than an absolute rule. Nevertheless, having a tool to adjust your profit expectations is invaluable, especially in the emotionally charged environment of day trading.

Example:

ATR based profit target

Past performance is not a reliable indicator of future results

2. Stop Placement

In swing trading, where positions are held over several trading sessions to capture price swings, using multiples of the ATR for stop placement is a smart strategy. It helps keep your stops outside of market noise and enhances risk management.

However, when it comes to day trading, it's understandable that stops need to be considerably smaller. But that doesn't mean we can't use ATR to fine-tune our stop loss levels according to market volatility.

Day traders can benefit from using a multiple of a lower timeframe ATR to establish a volatility-adjusted stop loss. This approach is often more effective than simply placing a stop below the nearest level of support. For day traders using a 5-minute candle chart, a stop set at 10 times the ATR on this timeframe is a reasonable starting point.

Keep in mind that ATR serves as a normaliser of price movement across different markets. Using ATR for stop placement allows for consistency in risk management across the various markets you trade.

For day traders who prefer locking in profits as a trade moves in their favour, an ATR trailing stop can be an invaluable tool. It trails the stop a certain number of ATRs below the close of a specified number of bars, dynamically adjusting to the market's volatility. TradingView offers numerous ATR trailing stop indicators just search for “ATR Trailing Stop” in the indicators tab.

Example:

ATR Trailing Stop Loss

Past performance is not a reliable indicator of future results

3. Measuring Overextension

Just as ATR proves invaluable in setting realistic profit targets calibrated to market volatility, it also serves as an objective measure to define when a market is overextended.

There are various methods to use ATR for this purpose, but one of the most straightforward approaches involves Keltner Channels, which envelop an ATR band on either side of an exponential moving average.

When the price moves beyond the boundaries of the Keltner Channels, it is considered overextended. Day traders can experiment with Keltner Channel settings. The standard setup involves using 2.5 times the ATR wrapped around a 20-period exponential moving average. Wider bands (a higher ATR multiplier) across a longer period of the moving average generate fewer signals, while narrower bands across a shorter period produce more signals.

Incorporating Keltner Channels, in conjunction with support and resistance levels, provides an additional layer of confirmation for day traders, enhancing their ability to assess overextension in the market.

Example:

Keltner Channels: S&P 500 5min Candle Chart

Past performance is not a reliable indicator of future results

In summary, ATR is a versatile tool for day traders, helping them navigate volatile markets with precision. It aids in setting realistic profit targets, fine-tuning stop placement, and identifying market overextension. By incorporating ATR into your trading strategy, you can make informed decisions and manage risk more effectively.

Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance.