Welles Wilder's ATR: The Volatility and Risk Management Tool

Understanding Welles Wilder's Average True Range

The Average True Range (ATR) is an indispensable tool for traders who want to measure and manage volatility. Developed by J. Welles Wilder Jr., the ATR is not a trend-following indicator like the RSI or ADX. Instead, it provides a measure of the degree of price volatility. The ATR is calculated as a moving average of the true range. The true range is the greatest of the following: the current high minus the current low; the absolute value of the current high minus the previous close; and the absolute value of the current low minus the previous close. By taking a moving average of the true range, the ATR smooths out the volatility and provides a more stable measure.

ATR for Stop-Loss Placement

One of the most practical applications of the ATR is for setting stop-loss orders. A common mistake that traders make is to use a fixed percentage or dollar amount for their stop-losses. This approach does not take into account the volatility of the market. In a volatile market, a tight stop-loss is likely to be triggered by normal price fluctuations, while in a quiet market, a wide stop-loss may be giving up too much profit. The ATR provides a solution to this problem. A trader can set their stop-loss at a multiple of the ATR. For example, a trader might place their stop-loss at 2 times the ATR below their entry price for a long position, or 2 times the ATR above their entry price for a short position. This approach ensures that the stop-loss is adapted to the current market volatility. For instance, if the ATR on SPY is 5 points, a trader might set their stop-loss at 10 points away from their entry price. If the ATR increases to 10 points, the trader would adjust their stop-loss to 20 points away.

The Chandelier Exit

A popular stop-loss technique that uses the ATR is the Chandelier Exit. The Chandelier Exit was developed by Chuck LeBeau and is calculated by subtracting a multiple of the ATR from the highest high of the trade for a long position, or adding a multiple of the ATR to the lowest low of the trade for a short position. The most common multiple to use is 3. For example, for a long position, the Chandelier Exit would be placed at the highest high of the trade minus 3 times the ATR. This creates a trailing stop-loss that is sensitive to volatility and allows the trade to have enough room to breathe.

ATR for Position Sizing

The ATR can also be used for position sizing. By taking into account the volatility of the market, a trader can adjust their position size to maintain a consistent level of risk. For example, a trader might risk 1% of their account on each trade. To calculate the position size, the trader would divide their risk amount by their stop-loss in dollars. The stop-loss in dollars is determined by the ATR. For example, if a trader has a $100,000 account and is willing to risk 1% ($1,000) on a trade in AAPL, and the stop-loss is set at 2 times the ATR, which is currently $5, the stop-loss in dollars would be $10. The position size would then be $1,000 / $10 = 100 shares. If the ATR increases, the stop-loss in dollars will also increase, and the position size will decrease, and vice versa. This ensures that the risk on each trade remains constant, regardless of the market volatility.

ATR and Breakouts

The ATR can also be used to confirm breakouts. A breakout from a consolidation range is more likely to be genuine if it is accompanied by an increase in the ATR. For example, if NQ has been trading in a narrow range and the ATR is low, a breakout above the range on high volume and a rising ATR is a strong signal that the breakout is valid. Traders can use this information to enter a trade with more confidence.

By incorporating the ATR into their trading plan, experienced traders can gain a significant edge. The ATR is a versatile tool that can be used for setting stop-losses, position sizing, and confirming breakouts. By understanding and applying the concepts discussed in this article, traders can improve their risk management and overall profitability.