For example, if you used a standard 10% stop, this would be a tighter stop (i.e. closer) for some securities than for others. If a security moves 5% a day on average, then a 10% stop would be tighter than for a security that only moves 1 ½% a day on average. Using ATR can alleviate this situation.
The concept of ‘average true range’, commonly referred to as ATR, is a measure of a security’s volatility. The true range of a security for any given day is the greatest of the following three distances:
The distance from yesterday’s close to today’s high
The distance from yesterday’s close to today’s low
The distance from today’s high to today’s low
The average true range is a moving average of the true ranges. In order to use ATR effectively, you need to ensure that a sufficient sample is taken. For example, obtaining a two day ATR or ATR (2) is not sufficient to provide you with a reasonable indication of that security’s normal daily movement. Whereas using at least 10 days in the average calculation, or an ATR (10) would provide you an indication of that security’s daily movement over the last 10 trading days (2 weeks). The ATR is usually expressed as ATR (X) where X is the number of days used in the calculation of the moving average. The number of periods you select to obtain the average would depend on your application.
One application of ATR is that they can be used quite effectively for setting exits, or stops. Using ATR for exits allows you to tailor your stop to the security you are trading. For example, if you used a standard 10% stop, this would be a tighter stop (i.e. closer) for some securities than for others. If a security moves 5% a day on average, then a 10% stop would be tighter than for a security that only moves 1 ½% a day on average. Using ATR can alleviate this situation.
To use ATR for exits, you would normally use a multiple of the ATR to ensure a sufficient gap between your exit and the security's normal price movement. Therefore, using the ATR without any modification would have your stop too close to the price and would not allow the security you are trading sufficient room to move and behave naturally. Depending on your trading style, you would normally consider using something in the order of 2 - 3.5 multiplied by the ATR as a suitable trailing exit. If you used a ‘2.5 ATR stop’, then your trailing stop will always be 2.5 times the ATR below the highest price the security has reached since you entered the trade.
Another application of ATR is to loosely categorise securities as blue chips, mid-capitalisation (mid-caps) or speculative companies. This concept is called Volatility Percentage. The calculation that is used is to take the ATR over the last 20 days and divide that by the closing price of the share and then multiply by 100 to determine a volatility percentage. The result will be an indication of what percentage the share moves on average on a daily basis. As a guide, you will discover that most mid-cap and blue chip companies have a volatility percentage of under 4% and anything above 5% is normally speculative. A value of under 1.5% indicates that it may be a property trust or a security that offers little potential for short to medium term gains.
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