How to use the Average True Range (ATR) day trading

When the breakout occurs, the stock is likely to experience a sharp move. For more insight, see:

Average True Range (ATR)

When the breakout occurs, the stock is likely to experience a sharp move. The ATR is another way of looking at volatility. In Figure 2, we see the same cyclical behavior in ATR shown in the bottom section of the chart as we saw with Bollinger Bands. Periods of low volatility, defined by low values of the ATR, are followed by large price moves.

The question traders face is how to profit from the volatility cycle. While the ATR doesn't tell us in which direction the breakout will occur, it can be added to the closing price , and the trader can buy whenever the next day's price trades above that value. This idea is shown in Figure 3. Trading signals occur relatively infrequently, but usually spot significant breakout points. The logic behind these signals is that, whenever price closes more than an ATR above the most recent close, a change in volatility has occurred.

Taking a long position is betting that the stock will follow through in the upward direction. Traders may choose to exit these trades by generating signals based on subtracting the value of the ATR from the close.

The same logic applies to this rule — whenever price closes more than one ATR below the most recent close, a significant change in the nature of the market has occurred. Closing a long position becomes a safe bet, because the stock is likely to enter a trading range or reverse direction at this point. For related reading, see: The use of the ATR is most commonly used as an exit method that can be applied no matter how the entry decision is made.

The chandelier exit places a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade. The value of this trailing stop is that it rapidly moves upward in response to the market action.

LeBeau chose the chandelier name because "just as a chandelier hangs down from the ceiling of a room, the chandelier exit hangs down from the high point or the ceiling of our trade. ATRs are, in some ways, superior to using a fixed percentage because they change based on the characteristics of the stock being traded, recognizing that volatility varies across issues and market conditions.

As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader's desire to protect profits with the necessity of allowing the stock to move within its normal range. A Logical Method of Stop Placement. ATR breakout systems can be used by strategies of any time frame. Setting stops and entry points at beneficial levels to prevent being stopped out or whipsawed are seen as benefits of this indicator.

It is not a leading indicator in that it divulges nothing related to price direction. High values suggest that stops be wider, as well as entry points to prevent having the market move quickly against you. With a percentage of the ATR reading, the trader can effectively act with orders involving proportionate sizing levels customized for the currency at hand. The ATR indicator is common on Metatrader4 trading software, and the calculation formula sequence involves these straightforward steps:.

Software programs perform the necessary computational work and produce an ATR indicator as displayed in the bottom portion of the following chart:. The ATR indicator is composed of a single fluctuating curve. If low values persist for a period of time, then the market is consolidating and a breakout may be in order.

The next article in this series on the ATR indicator will discuss how this oscillator is used in forex trading and how to read the various graphical signals that are generated. Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors.