Confused how to decode a breakout or a breakdown? Use ATR for winning trade

NEW DELHI: Are you confused how to read a breakout or a breakdown? The average true range (ATR) indicator can help you decode the enthusiasm behind such a move.

Traders are often caught in a bind after a large move on either side. To validate the authenticity of such a move, traders can use the ATR indicator.

Typically, the ATR is based on 14-period intervals and can be calculated on a daily, weekly or hourly basis. ATR is generally used in tandem with directional indicators such as RSI or MACD.

“ATR is the basic unit to measure volatility. A volatility system is a trend-following system and is also a true reversal system that means the position is reversed at every stop,” Birendrakumar Singh, AVP for Technical Research at Systematix Shares & Stocks, told ETMarkets.com.

To understand ATR, let’s first understand what is true range. True range is calculated as the maximum value of the following three equations.

a. High for the day less low for the day

b. High for the day less previous close

c. Current low less the previous close

“The difference between each equation is considered as a range and the true range is the maximum value of the three equations. ATR is the average of true ranges. Traders can calculate the above figures for any period of their choice based on their requirement,” Mazhar Mohammad, Chief Strategist - Technical Research & Trading Advisory, Chartviewindia.in, told ETMarkets.com.

“During a breakout or a breakdown, the range will be higher, marking the beginning of a fresh directional move, which can be captured with the help of ATR,” he said.

ATR is based on the true range, which uses absolute price changes and is not comparable between stocks. Low-priced stocks would have lower ATR compared with high-priced stocks. Traders can make use of this indicator by reviewing entry or exit points.

Mohammad said ATR helps figure out entry or exit points along with stop loss strategies. It is said that the famous 'Turtle Trading' system had a stop loss strategy based on ATR.

How to arrive at conclusions:
ATR does not give any indication on the direction of the market but reflects the degree of interest or disinterest in any large significant move on either side. Why is it important to validate such a move?

A call taken on the basis of a breakout or breakdown can lead to a whipsaw moment if the market quickly moves in the opposite direction.



A bullish breakout with an increase in ATR would show strong buying interest. On the other hand, a bearish support break with an increase in ATR would indicate strong selling pressure.

“Higher ATR should signal that the indices have recently witnessed increased volatility and buying around these levels would be prudent. Please note that stock markets calculate volatility more by how much the indices move down rather than how volatile the price action actually has been on either direction,” Nikhil Kamath, Co-Founder & Director, Zerodha, told ETMarkets.com.

“For example, a sudden move on the higher side of say 50 points may not affect the volatility number, but a move down in the same proportion will increase the volatility score,” he said.

Kamath said ATR works better in a rangebound market, wherein the price action regresses to the mean periodically.

When to avoid usage of ATR?
This indicator is not suited for a trending market as the ATR levels may remain near their extremes for prolonged durations, experts said.

It should never be used just by itself but as part of a larger trading system. Traders should look for this signal to validate trade generated by your trading system to ensure that you are not entering the market in times of extreme uncertainty.

“ATR works better in a rangebound market when price action regresses to the mean periodically. This indicator is not suited for a trending market, as the ATR level may remain near its extremes for prolonged durations,” Kamath said.