The ATR was developed simply by J. Welles Wilder to evaluate the volatility of price adjustments, initially for the commodities and later adapted towards stock market as volatility in stocks rose substantially within the last 40 years. The ATR is not an entry or exit indicator so it's not as popular as some other indicators such as the moving average or the Stochastic Indicator. However, the ATR is one powerful indicator if used correctly can increase your current profits and help you minimize risk concurrently. The ATR was originally made for daily charts but since volatility picked up so much throughout the last several decades, the indicator can be employed just as effectively for intraday analysis.
Contrary to several technical signals, the ATR is extremely all too easy to calculate and just as easy to navigate. The ATR simply calculates the ideal values of the following 3 differences, and calculates the moving average with the resulting data series:
• Between the prior day's high and low price.
• Between the previous day's close price plus the current day's high price.
• Between the prior day's close price and the existing day's low price.
When used for day investing the formula simply changes any time frame from daily to intraday and the formula will take care for the rest. The ATR is build into most technical analysis software platforms so you won't need to manually calculate anything yourself. The one change I make is I average one more 10 days or trading bars while the original formula averaged the ATR for 14 days or bars. I find that the shorter time frame makes the actual ATR react quicker to dynamic changes in volatility that occurs in today's markets.
If you were trading the actual E-mini SP Futures contract and you used a tight stop loss in January on this year you would probably be smart but if you used the same type of stop loss inside April of this year choosing stopped out before giving your trade the ability to work in your way. Similarly, notice this chart of GLD that is an ETF designed to trail the Gold market. This 15 minute chart demonstrates the fact that average trading range jumps from $0.20 cents to in excess of $0.50 cents in one trading day. Many traders utilize the trading range to determine their stop loss placement, imagine if your stop loss level was depending on $0. 20 cent range when the market is trading at a new $0.50 cent range.
Let me show you a number of examples how the ATR measure volatility so as to see how I use this indicator in real time. In this example you can easily see the E-mini SP Futures contract. I specifically wanted to use this example because you can observe how the Index starts off with relatively low volatility as well as consistent trading range and in the latter perhaps the example you can see the fact that volatility picks up and the ATR increases simultaneously with the increase of volatility.
What's great about the ATR is that the numbers that are produced derive from actual dollar values of the market your trading. Imagine you are trading using an indicator like the RSI giving you an overbought or oversold level. The ATR actually uses dollar values to help you easily make modifications to your current stop loss and profit target levels while using actual dollar changes you are usually seeing. In this example you can observe how I adjust my stop loss level while using volatility and more importantly the actual ATR average reading that I'm monitoring in real time. Notice how the stop loss moves dynamically as volatility boosts. Thank god for electronic trading, imagine having to call the broker each and every time I make changes.
Now that you understand the fact that ATR is calculated and dynamically changes while using actual volatility it's time to find out how to place actual requests. What I typically do is multiply the existing ATR level by 2 as well as subtract that from my entry price if I want to go long. If I'm going short I multiply the existing ATR * 2 and I add it to my entry price. Once there is a 20 % increase or decrease in volatility I repeat the process all over again. I keep doing this as often as I must.
Profit targets are calculated in the same way, I take the current ATR as well as I multiply it by *4 as well as add that to my entry price. If I'm going short I most certainly will subtract 4*ATR from my entry price.
The ATR is the obvious way to measure volatility of your existing position. It can be combined with daily or intraday charts successfully. The only change you must make is to adjust it to make use of 10 bars instead of 14 to make it much more dynamic. The ATR is very dynamic so avoid being afraid to make adjustments in your order as often as important. Don't forget to subtract the actual ATR for your entry while you are going long for stops also to add it to your entry when you’re using it for profit targets. Reverse this for short positions and you should do just fine.