Average True Range and Volatility Stops

Stop-losses set at arbitrary dollar amounts or fixed percentages often get triggered by normal price fluctuations. Average True Range (ATR) solves this by measuring actual volatility and allowing stops to expand or contract based on how much a security typically moves. The result: fewer false exits during choppy markets, and tighter protection when volatility compresses.

What Average True Range Measures

ATR quantifies the average price range over a specified period, accounting for gaps between sessions. Developed by J. Welles Wilder Jr. in 1978, ATR captures volatility more accurately than simple high-low ranges because it includes overnight price changes.

True Range is the greatest of three values:

1. Current High minus Current Low
2. Absolute value of (Current High minus Previous Close)
3. Absolute value of (Current Low minus Previous Close)

The "true" in True Range matters because it captures gap moves. If a stock closes at $50.00, then opens the next day at $52.00 and trades between $52.00 and $53.50, the simple high-low range is only $1.50. But the True Range is $3.50 (Current High of $53.50 minus Previous Close of $50.00), reflecting the full extent of price movement.

ATR Formula:

ATR = [(Prior ATR x (n-1)) + Current TR] / n

Where n = number of periods (commonly 14)

The standard 14-period setting was Wilder's original recommendation. Shorter periods (7-10) react faster to volatility changes but produce choppier readings. Longer periods (20-22) smooth the output but lag significant volatility shifts.

ATR Calculation Example

Consider a stock with the following 5-day price data:

Day 2 True Range calculation:

• High minus Low: $49.25 - $48.10 = $1.15
• High minus Previous Close: $49.25 - $48.20 = $1.05
• Low minus Previous Close: |$48.10 - $48.20| = $0.10
• True Range = $1.15 (the greatest value)

Day 3 True Range calculation:

• High minus Low: $48.75 - $47.50 = $1.25
• High minus Previous Close: |$48.75 - $48.90| = $0.15
• Low minus Previous Close: |$47.50 - $48.90| = $1.40
• True Range = $1.40 (captures the gap down)

Simple 5-period ATR: ($0.90 + $1.15 + $1.40 + $0.95 + $1.00) / 5 = $1.08

This $1.08 represents the average daily price range for this stock. A stop placed less than $1.08 from the current price has a high probability of getting triggered by normal daily fluctuation.

Setting Volatility-Based Stops

The core principle: multiply ATR by a factor to set stop distance. Common multipliers range from 1.5x to 3.0x ATR.

Standard ATR Stop Multipliers:

• 1.5x ATR: Tight stop; appropriate for mean-reversion strategies or low-volatility regimes
• 2.0x ATR: Standard stop; balances protection against premature exits
• 2.5x ATR: Wider stop; suitable for trend-following or higher-volatility securities
• 3.0x ATR: Very wide stop; used for longer-term position trades or highly volatile stocks

Worked Example:

You enter a long position in a stock at $85.00. The 14-period daily ATR is $2.40.

Using a 2.0x ATR multiplier:

• Stop distance: 2.0 x $2.40 = $4.80
• Initial stop level: $85.00 - $4.80 = $80.20

Using a 2.5x ATR multiplier:

• Stop distance: 2.5 x $2.40 = $6.00
• Initial stop level: $85.00 - $6.00 = $79.00

The 2.0x stop risks $4.80 per share (5.6% of entry price). The 2.5x stop risks $6.00 per share (7.1%). Your position size should reflect this risk amount.

Trailing Stops with ATR (Chandelier Exit)

A trailing stop using ATR adjusts as both price and volatility change. The Chandelier Exit, developed by Charles Le Beau, trails from the highest high:

Long Position Chandelier Exit: Stop = Highest High (over n periods) - (Multiplier x ATR)

Short Position Chandelier Exit: Stop = Lowest Low (over n periods) + (Multiplier x ATR)

Example progression:

Entry at $85.00. 14-period ATR = $2.40. Using 3.0x multiplier and 22-period highest high:

As the stock advances, the stop ratchets higher. Notice in Week 4: even though price stayed flat (same 22-period high), the stop still rose because ATR decreased from $2.70 to $2.50. The stop adapts to both trend progress and volatility changes.

Comparing ATR Across Securities

ATR values are not directly comparable between stocks at different price levels. A $200 stock with $4.00 ATR and a $50 stock with $2.00 ATR have different volatility profiles in percentage terms.

ATR as percentage of price:

• $200 stock: $4.00 / $200 = 2.0% daily volatility
• $50 stock: $2.00 / $50 = 4.0% daily volatility

The $50 stock is actually twice as volatile in relative terms. When comparing volatility across securities or setting portfolio-wide stop rules, convert ATR to percentage terms.

Typical ATR Percentage Ranges:

• Large-cap S&P 500 stocks: 1.0% - 2.5% daily
• Mid-cap stocks: 1.5% - 3.5% daily
• Small-cap stocks: 2.0% - 5.0% daily
• High-beta technology stocks: 2.5% - 6.0% daily

Risks and Limitations

ATR does not predict direction. A high ATR means large price swings in either direction, not that a move up or down is more likely. ATR is purely a volatility measure.

ATR lags volatility spikes. Because ATR uses an average, it takes several periods to fully reflect a sudden volatility increase. After a large gap or shock move, the initial ATR reading will understate current volatility until more high-volatility periods enter the calculation.

Multiplier selection is discretionary. There is no universally correct ATR multiplier. A 2.0x stop that works well in trending markets may cause excessive whipsaws in sideways markets. A 3.0x stop that preserves trends may give back too much profit during reversals.

ATR stops can be very wide in volatile markets. If ATR is 5% of price and you use a 2.5x multiplier, your stop is 12.5% away from entry. This requires either accepting large potential losses or reducing position size proportionally.

Stops clustered at ATR levels. Because ATR-based stops are popular, many traders place stops at similar levels (particularly round multiples). Price can gravitate toward these clusters before reversing.

When ATR-Based Stops Work Best

Trending markets: ATR stops allow room for pullbacks within trends rather than exiting on normal retracements.

Securities with consistent volatility patterns: Stocks that maintain relatively stable ATR readings over time produce more reliable stop distances.

Position sizing integration: When combined with fixed-risk position sizing (risking a set percentage of capital per trade), ATR stops create consistent risk exposure regardless of the security's volatility.

When they struggle:

• Range-bound markets where price oscillates between support and resistance
• Around major news events when volatility spikes unpredictably
• In securities with highly variable ATR (biotech announcements, earnings reactions)

Next Steps

1. Calculate 14-period ATR for securities you trade regularly and note how much they move daily in both dollar and percentage terms
2. Backtest different multipliers (1.5x, 2.0x, 2.5x, 3.0x) on historical trades to determine which setting reduces false exits without giving back excessive profits
3. Compare ATR percentage across your watchlist to identify which securities require wider stops due to higher relative volatility
4. Implement a trailing ATR stop on at least one position to observe how it adjusts through different volatility regimes
5. Set position sizes so that your ATR-based stop risk equals a consistent dollar amount or portfolio percentage per trade

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Related: Volume Analysis and On-Balance Volume | Fibonacci Retracements and Extensions | Risk Management for Chart-Based Trades

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Source: Wilder, J. Welles Jr. New Concepts in Technical Trading Systems (1978). StockCharts.com, ChartSchool: Average True Range (ATR).