Average True Range: Size Stops and Positions Right

Key Takeaways

• ATR measures the greatest of three ranges per bar, high minus low, high minus prior close, and low minus prior close, capturing overnight gaps that a simple range would miss.
• A 2-ATR stop placed below entry scales automatically to the asset's own volatility rather than using a fixed dollar distance for all trades.
• ATR says nothing about price direction; a rising ATR during a rally and during a crash both simply mean volatility is increasing.
• Divide ATR by price to get ATR percent for meaningful cross-asset comparison, a $2 ATR on a $40 stock is very different risk than on a $400 stock.

What It Is

Average True Range was introduced by J. Welles Wilder Jr. in his 1978 book New Concepts in Technical Trading Systems. Wilder designed it for commodities, where overnight gaps and limit moves made a simple high-minus-low range misleading. ATR captures the full magnitude of a period's movement, including any gap from the prior close.

The indicator outputs a single number per bar in the same units as the price (for example, dollars for a stock, points for an index). A stock with an ATR of 2.00 has moved, on average, about $2 per day over the lookback window.

The Intuition

A $300 stock that swings $3 a day is behaving very differently from a $30 stock that swings $3 a day, even though both moves are identical in dollar terms. ATR gives you a consistent yardstick for "how big is a normal move?" across assets and across time. Once you know that number, you can set stops, targets, and position sizes that scale with volatility instead of using the same dollar distance for every trade.

ATR says nothing about whether price is going up or down. A rising ATR during a rally means the rally is getting more volatile. A rising ATR during a selloff means the selloff is accelerating. Direction has to come from a separate indicator.

How It Works

ATR is built in two steps. First, you compute True Range (TR) for each bar as the greatest of three values:

TR = max(
    High - Low,
    |High - PreviousClose|,
    |Low  - PreviousClose|
)

The absolute values ensure TR is always positive. The second and third terms capture overnight gaps that a plain high-minus-low range would miss.

Second, you smooth the True Range series over N periods. Wilder's default N is 14. His smoothing method, now known as Wilder smoothing, is:

First ATR   = simple average of the first 14 TR values
Current ATR = ((Prior ATR * 13) + Current TR) / 14

This is mathematically equivalent to an exponential moving average with alpha = 1 / N. Some charting platforms instead offer a plain simple moving average of TR, which reacts faster but behaves differently. The two methods can produce visibly different ATR values, so always check which one your platform uses.

Worked Example

Suppose a stock shows these numbers on a given day:

• Previous close: 100.00
• Today's high: 103.50
• Today's low: 99.00

The three candidate ranges are:

• High minus Low: 103.50 - 99.00 = 4.50
• |High - Previous Close|: |103.50 - 100.00| = 3.50
• |Low - Previous Close|: |99.00 - 100.00| = 1.00

True Range is the largest: 4.50.

Now suppose yesterday's 14-period ATR was 3.00. Using Wilder's formula:

New ATR = ((3.00 * 13) + 4.50) / 14 = 43.50 / 14 = 3.11

If a trader wanted a 2-ATR stop on a long entry at 103, the stop would sit 6.22 below entry, near 96.78. Across a portfolio, the same 2-ATR rule scales the stop distance to each asset's own volatility.

Common Mistakes

1. Using ATR as a direction signal. ATR measures how much price moves, not which way. A rising ATR can accompany a rally, a crash, or a choppy whipsaw. Reading rising ATR as "bullish" or "bearish" is a category error.

2. Ignoring the smoothing method. Wilder smoothing is much slower to react than a simple moving average of TR. If you backtest a strategy with one method and trade it with the other, your live results will not match your tests. Know which your charting platform uses.

3. Applying the same ATR multiplier across very different assets. A 2-ATR stop on a low-priced volatile microcap is not the same kind of risk as a 2-ATR stop on a mega-cap. The ATR adjusts for nominal volatility, but position sizing still has to scale dollar risk to account total equity.

4. Comparing ATR values across stocks directly. An ATR of 2.00 on a $40 stock is five percent of price; on a $400 stock it is half a percent. For cross-asset comparison, divide ATR by price to get ATR percent (sometimes called ATRP).

5. Using a tiny lookback and getting surprised by outliers. A 3-period ATR reacts to a single large bar and can double overnight. Wilder chose 14 because it is long enough to smooth and short enough to stay current. Shorten it only with a reason.

Frequently Asked Questions

Q: What is average true range in simple terms? ATR is a number that tells you how many dollars (or points) an asset typically moves in one period. A stock with an ATR of $3 has been moving about $3 per day on average over the lookback window, up, down, or sideways combined.

Q: How does average true range affect investment decisions? It allows position sizing that scales to actual market conditions. If your risk tolerance is $200 per trade and ATR is $4, a 2-ATR stop requires a position of 25 shares. When ATR rises to $8, the same dollar risk cuts position size to 12.5 shares automatically.

Q: What is a real-world example of ATR in stop placement? A trader buys SPY at 510 with a 14-day ATR of 8.00. Using a 2-ATR stop rule, the stop is placed at 510 minus 16, or 494. That distance gives the trade room to breathe through normal daily moves without getting stopped out on routine volatility.

Q: How can investors use ATR practically? Use ATR to set stops and targets rather than arbitrary dollar amounts. A simple rule: never use a stop tighter than 1 ATR from entry, closer than that gets hit by normal daily noise, not by a genuine adverse move.

Q: How is ATR different from standard deviation? ATR uses the true range, which includes overnight gaps, and outputs a dollar-denominated volatility measure per bar. Standard deviation measures how much closing prices vary around their average over a window, expressed as a percentage or price unit. Bollinger Bands use standard deviation; ATR is preferred for stop sizing.

Sources

1. StockCharts ChartSchool. "Average True Range (ATR) and Average True Range Percent (ATRP)." https://chartschool.stockcharts.com/table-of-contents/technical-indicators-and-overlays/technical-indicators/average-true-range-atr-and-average-true-range-percent-atrp
2. Wilder, J.W. (1978). New Concepts in Technical Trading Systems. Trend Research. https://archive.org/details/newconceptsintec00wild
3. Macroption. "ATR Calculation Methods and Formulas." https://www.macroption.com/atr-calculation/
4. Britannica Money. "Average True Range Indicator: What Is It & How to Calculate." https://www.britannica.com/money/average-true-range-indicator

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.