In the previous post on technical trader, we covered how Average true range (ATR) can be used in conjunction with flat lines for technical analysis. I feel it is an amazing tool by itself and will discuss some use cases where it can be used effectively along with other indicators
The contents of this post will be
What is ATR?
How to plot ATR
How to identify volatile markets
How to use ATR in a trade
What is ATR
ATR stands for Average true range. It is a unique indicator and does not measure trend, momentum or over brought or over sold levels. Then what is it?
As per investopedia, Average true range (ATR) is a technical indicator measuring market volatility. It is typically derived from the 14-day moving average of a series of true range indicators. It was originally developed for use in commodities markets but has since been applied to all types of securities.
How to plot ATR?
I plot 14 day ATR as a line chart on my charting tool. When I look at the line, it gives me an idea about volatility. When ATR is rising, the range of the stock will be rising and the premium for the options might also increase. I personally use TC2000 as my charting software. ATR can also be plotted as line, area or histogram. I personally use ATR on the daily and weekly chart for my trading strategies. In the chart below, you can see ATR going up on the daily chart
TC2000 Daily SPY chart Brown line on the bottom refers to ATR
How to identify if market is volatile
There are three types of market – Bullish, bearish and sideways. I am planning to write a separate post about identifying the market types above using technical indicators such as ichimoku and moving averages. Each of the markets types behavior can be of two types – volatile and quiet. Market behavior alternates between volatile and quiet.
When the market behavior is quiet, ATR is normal range. Normal range for SPY most of 2019 is around 6 on the weekly chart. When the market is volatile, ATR of the market breaks out of the normal range and starts increasing. If we remember market started faling from February, 2020 to March 2020 and then started rising. Look at the ATR in the weekly chart of SPY ( brown line). ATR was at 6$ before that fall and it started rising when the market started falling and it further rose when the market rose from march to may to a high of 25.59. That is the reason we saw such big moves in all the stocks. One thing to note is that ATR went up irrespective of the direction. if you look at the current ATR, it is still around 12$ and is not as low as 6$ which was maintained from April 2019 ( before the fall)
Tc2000 weekly chart of SPY
How to use ATR in a trade
ATR provides you the range that the stock can be in a time frame concerned. ATR can be used for either a sell order or for a stop loss on a trade. Usually, traders use the multiples of ATR such as 2, 3,4,5. Usually, what I have seen is that if the direction has been the same for ATR multiple of 3 on the weekly chart, the stock looks exhausted and may retrace. But, recently, before the fall, there have been multiples of 5 on the upside. However, when it exceeds above the ATR suggested, there might be an opportunity to play the pull back in the stock price.