Average True Range or ATR is a technical indicator in a sea of hundreds of indicators available for traders on the various platforms , ATR as the name suggests gives us the average range of the stock , the range can be large or small that depends on the individual stock or the market , ATR has several uses and can be a very useful tool for any trader , below we will dive deep into the meaning of ATR as well as learn the practical uses of ATR indicator.
What is ATR ?
As discussed above ATR is the average true range of a stock or the market , it measures the volatility of a particular stock or the market , the ATR indicator gives us the average range that a stock or market can move in either direction , of course the stock can move more than that due to some fundamental change or some news but ATR will be the value that the stock will respect in absence of some other catalyst related to the stock or market , hence ATR or average true range gives the daily volatility level of individual stock but how can we use ATR ? Below we have discussed three ways in which ATR indicator can be used while trading stocks or index.
Using ATR to place stop loss on technical charts –
ATR indicator can be used to place stop loss , many a times traders put their stop losses just near the resistance or the support levels but this should be avoided as the market is dominated nowadays by the algos and the creators of algos know the mentality of a general retail trader , they deploy the algos in such a way that the stop losses of these retail traders are hit and they are stopped out of trades , several times you might have seen fake breakouts or fakeouts these are also sometimes the result of such stop loss hunting by other institutional traders .
Above is the chart of Ashok Leyland as traded on NSE , a resistance level was made on the chart which later acted as the support and we saw a morning star candlestick pattern at the support but what should have been the stop loss for going long on the pullback to the support ? Just below the support ? low of the candlestick ? well these can be stop loss levels but a much better stop loss would be the level that you choose minus the ATR value , in this case the stop loss would have been 131.75 minus 4.36 that is 127.39 , so that would ensure that our stop wouldn’t be hunted and we would remain in the trade , in more volatile stocks one can use the level- 0.5 ATR also that is only subtract half the ATR , in less volatile stocks like in the example above we can use the 1 ATR and subtract it to come at a more logical stop loss for bullish trades , likewise for bearish trades one can keep the stop loss at the level you chosen plus the ATR value.
Using ATR to anticipate breakouts on technical charts –
Another use of the Average True Range or ATR is to anticipate and trade breakouts or breakdowns on any technical chart , the market generally moves from a state of low volatility to a higher volatility , that is volatility contraction leads to volatility expansion which can also be termed as a breakdown or breakout , since ATR indicates the volatility we can use it to find such volatility contraction areas near the support resistance areas and use it to anticipate breakouts or breakdowns.
Above is the technical chart of Infosys as traded on NSE , the stock moved into the resistance area marked by the orange lines , also while moving up it formed higher lows into resistance which is an ascending triangle so the stock formed an ascending triangle and then the stock consolidated at the resistance and the volatility reduced which was clearly seen on the ATR indicator , ATR dropped significantly and volatility contraction occurred , what follows is a good breakout and the stock shot up , we have already discussed how to spot these breakouts in our previous articles here , the volatility contraction near an area of value that is a support resistance area can lead to a breakout or a breakdown .
Using ATR to stop FOMO ( Fear of missing out )-
ATR can be used to stop a trader from losing out and getting trapped due to FOMO ( Fear of Missing Out ) , we have seen plenty of times a stock shoots up or down and a trader doesn’t want to loose out on such a bullish or bearish stock and wants a piece of the cake for himself , so he/she chases the stock and as soon as he buys or sells the stock starts moving against his anticipated direction , doesn’t that sound familiar ? It has happened to every trader , ATR can help in preventing this mishap to a certain extent.
Above is the 5 minute technical chart of L&T as traded on NSE , the stock ran up about more than 30 points up that day which was very close to the ATR value of 34 , the chart also made the famous ABCD day trading pattern , but if any trader who spotted it late and would have thought to buy due to FOMO that should have been a very bad level as the stock had already ran the average range thus it would be equal to buying on the tops , if there is no catalyst or fundamental news then ATR will generally be respected and the stock wouldn’t move more than the ATR value thus buying or selling short should be avoided when the stock has already ran equal to the ATR unless there is a news or catalyst.
This concept is to be applied to a lower time frame like 5 minute chart , this technique is best suited for day traders as when the stock has already given a larger move which is more than equal to ATR the trader should avoid buying at that level and should wait for the dips or specific day trading patterns to manifest for initiating long positions.
Final thoughts on ATR –
As we have discussed the ATR or Average True Range has multiple uses , and thus is a very handy tool for any trader , But just like any other technical indicator over reliance on any indicator is not a good thing , price is king and price action should be given importance over any indicator , using ATR can be beneficial for traders but it shouldn’t be used in isolation and should be used together with proper price action and area of values .