ATR: measuring volatility

What ATR measures

Average True Range, also from J. Welles Wilder Jr.'s 1978 book, measures volatility. It does not say whether price is rising or falling. It says how big the bars have recently been, including gaps, expressed in the instrument's own price units, so on a futures contract it is in points or ticks.

True range

A plain high minus low ignores gaps between bars. True range fixes that by taking the largest of three distances:

From true range to ATR

ATR is a smoothed average of true range, 14 periods by default. The first value is a plain average of the first 14 true ranges; after that Wilder smoothing is applied:

The line rises when recent bars get larger and falls when markets quiet down. Because it is just a number of price units, ATR on a five-minute chart and ATR on a daily chart are not comparable; always read it on the timeframe you trade.

Using ATR for stop placement

A fixed stop in ticks is too tight in a volatile market and too wide in a quiet one. Many traders instead place stops a multiple of ATR away from their entry or from a swing point, so the stop breathes with the market. Multiples between roughly 1.5 and 3 are commonly discussed, and the right one depends on the strategy and is something to test, not a rule. A wider ATR stop means each contract risks more dollars, which leads to sizing.

Using ATR for position sizing

Position size follows from the dollars you are willing to risk and the stop distance:

As pure arithmetic: if the E-mini S&P 500 (ES) is worth $50 per point, an ATR of 4 points and a stop of 1.5 ATR gives a 6 point stop, or $300 of risk per contract. A trader risking $300 per trade would take one contract; the Micro E-mini (MES), worth $5 per point, would allow ten. This is an illustration of the formula, not a recommendation of any risk level. When ATR doubles, the same dollar risk buys half the size.

Choosing the ATR period

Fourteen is the default, but it is only a default. A shorter ATR, such as 5 or 7, follows the latest volatility closely and suits fast markets; a longer one, such as 20 or 50, is steadier and better for sizing swing positions. When you change the period, remember that stop distances and position sizes calculated from it will change too, so keep your risk rules consistent with the setting you test.

Other uses

• Volatility regime filter. Rising ATR can warn that conditions have changed from the ones a strategy was built for.
• Profit targets. Some traders express targets as multiples of ATR so they scale with conditions.
• Trailing stops. Chandelier-style trailing stops hang a multiple of ATR from the highest high since entry.

Limitations

• It lags: ATR can be low just before a volatility spike.
• It is non-directional, so it never tells you which side to trade.
• It averages across the day, so the opening and lunch hours are blended together even though they behave differently.

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Quick answers

What is a good ATR multiple for a stop?

There is no universal answer. Multiples from about 1.5 to 3 are commonly discussed, and the right value depends on your strategy, market and timeframe.

Does ATR show trend direction?

No. ATR only measures the size of recent price movement, never its direction.

Why is ATR using true range rather than high minus low?

True range includes gaps from the previous close, so overnight and opening gaps are counted as part of the market's movement.

Keep reading

Educational only, not financial advice. Futures trading involves substantial risk of loss.