Using ATR when trading options

Recently many users have shared stories with me about successes they had with our ‘buy cheap calls’ pre-defined report. This report is located on our scanner. The main component in that scanner is the ATR filter. So I thought it could be a good opportunity to share more information about the ATR filter in Option Samurai and how to use it.

What is ATR

ATR or Average True Range is a technical analysis indicator to measure volatility of an asset. Originally developed by J Welled Wilder for commodities, it has gained popularity among technical analysts and is now widely used.  The goal of the indicator is to find the “true” movement range for a stock in order to assess its volatility.

The calculation of the True Range (TR) is:

TR = The maximum of:

  1. Current High – Current Low
  2. Yesterday’s close – Current High (Absolute value)
  3. Yesterday’s close – Current Low (Absolute value)
True Range Example
True Range Example

The ATR is usually a 14 days average of the TR value.

ATR is a Volatility measure of the stock based on past price action. It is a much more intuitive measure than standard deviation for example.

Using ATR when trading options

One of the most important characteristic when trading options is the assumption for the asset volatility. When we use ATR we can standardize the volatility for different assets and compare trades on different stocks, although the different stocks have different volatility.

For example:

ATR Example
ATR Example – SPY AAPL GOOG

In the following example we can see search results for SPY, AAPL and GOOG.

  • SPY has a lower volatility from these stocks, and we can see that the ATR % for SPY is 0.58% (this means that average DAILY move of the SPY is 0.58%)
  • AAPL and GOOG have similar volatility in percentage ~1.4%.
  • If we would only look at the break even point, we can see that the BE point for SPY is 0.6% from the current price, while AAPL’s BE point is 1.36% away and GOOG is 0.7%.
  • When we take into consideration the stock volatility however, we can see that GOOG is most likely to pass BE point (GOOG daily range is 1.4% and the BE point is 0.7% – the daily range is twice the break-even point).
  • Although AAPL Break even is 1.36% and SPY BE point is 0.6%, when considering the volatility, we can see that BE point is 1 ATR away from both stocks.

This is the main power of using the ATR in option scanning – the standardization allows you to compare different stocks and different parameters and adjust the volatility. Because it takes into account the volatility, it is superior to regular percentage measures. 

How to use the ATR in trading

The ATR will allow us to standardize volatility of different assets and look at distances in “ATR-units” which will allow us an ‘apples to apples’ comparison of different assets. We can use it in several ways:

1. Find cheap options

When we buy options, the option premium should be enough to cover the potential move of the stock so the option seller will have enough margin of safety to expect profit.

Using the ‘ATR VS Break-even Point‘ filter we can make sure that the premium we pay is relatively low compared with the stock volatility (see more in the example). Since we can’t lose more than the price we paid, buying cheap options can give a real edge in the market compared with buying the stock.

2. Choose the right strike to sell options

We can also use the ATR to find the right strikes to sell. Using ATR you can find strikes that are N amount of “ATR units” from current price. This means that the distance depends on the stock volatility – the more volatile the stock, the further away the strike will be.

Using the filter ‘ATR vs Strike’ you can easily find strikes that are far X amount of ATR units from current price. This saves you time and allows you to compare different trades for different stocks and ETFs.

3. Wide profit zone

When trading Iron Condors you can make sure that the ‘profit zone’ of the iron condor covers what you are looking for. There are 3 filters you can use:

  1. ATR to Upper Breakeven
  2. ATR to Lower Breakeven
  3. Profit range ATR

These filters give you more control when scanning for Iron Condors, as you can control the distance to the upper break-even point, lower break-even point and the total width of the profit zone – all in “ATR units” (see examples below for usage).

Example 1: Using ATR when buying calls

In our predefind section you can find the ‘Buy cheap calls’ scanner. We discussed it’s edge in an previous blog post.

Buy Cheap calls
Buy Cheap calls scanner

This filter is looking to buy calls that have more than 15 days to expiration, max loss of less than 5% compared to buying the stock (serves as a stop loss) and break even point is less than 3% (meaning if the stock rises 3% by expiration the position is profitable.

The most important parts of this scan is no dividend (which adjust the price down) and ATR needs to be 3 times the Break-even point (ATR vs BE point). This increases the probability to exceed the break-even point and show profit.

Some more ideas on how to integrate this in your trading:

  1. You can sort by ATR vs BE point to see the ‘cheapest’ opportunities
  2. You can add the ATR vs BE point to your watchlists to see this data column in your results.
  3. You can change the value from 3 to a higher or lower value in your screens to better adjust your results.

Go to Option Samurai and try it now for yourself

Example 2: Using ATR when selling Iron Condors

Iron condors are a very popular strategy. It allows users to enjoy the time decay of the options (increases the probability of profit), while benefiting from a limited risk trade.

In this example, we will use our Iron condor filter to check all possible combinations (hundreds of millions of option combinations) and find the best Iron Condors (IC) that fits our cretiria.

Below are the results for Iron condors that:

  • Up to 30 days to expiration, any IV rank and total option volume > 5000
  • IC profit is above $200, loss is below $5,000 and expected value is profitable
  • We added ATR measures: the break even point above should be more than 1 ATR, below needs to be more than 2 ATR and the entire range should be more than 5 ATR.
  • We also added the ATR percentage to the table to compare.
Results for top IC with more than 5 ATR range
Results for top IC with more than 5 ATR range

 

This table shows us variety of results with different volatility. We can pick the strategies that best fit our risk criteria.

For example:

  • NTES trade has about 21% profit zone. About 10% to each side. The expected value is $302, which teaches us that this trade has high probability of profit.  When analyzing this trade in ATR units: We can see that the Break evens are 3 ATRs on the upside and 2.5 ATR on the downside.
  • Due to the earning date, CMG allows for a 9 ATR profit range. 5 ATR on the upside and almost 4 ATR on the downside. Expected value is $248 and probability of profit is 73% (but this statistic is skewed due to the earning event prior to expiration (so this trade is not for everybody)

Some more ideas on how to integrate this in your trading:

  1. You can sort by the ATR measures to make sure you have enough margin of safety (or no margin if you are buying straddle)
  2. You can limit results to have more than X amount of ATR and high IV rank

 

Summary

The ATR is a technical measure of volatility of an asset. We use it in option trading in an effort to compare different trades on assets with different volatility. Using the ATR instead of normal percent measure helps us to save time as we can focus our analysis on the best trades (risk-reward wise) while taking into consideration the fact that different stocks have different volatility.

When selling options, we are looking to sell options that have the most ‘ATR units’ of distance from current price.

When buying options, we are looking to buy options that are the closest to the price (ATR-units-wise) and we do it by comparing the ATR to the break-even point and asking the ATR to be as big as possible compared to it.

Go to Option Samurai

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