When you trade options and want to understand how likely you are to profit, running ATR backtests is essential. This article will show you how ATR helps measure market volatility and how Option Samurai’s tools can identify profitable trades by analyzing stock movements and ATR values.
Key takeaways
- ATR measures market volatility, telling you how much a stock typically moves in a given period.
- You can use Samurai to find profitable options trades if the stock moves X amount of ATR.
- A stock that has not moved up or down by 1 ATR in a while may present an opportunity for profitable long calls, puts, or straddles.
- Option Samurai offers a free backtesting tool and predefined screens to help you identify and trade these opportunities.
What Is ATR (and What Does It Tell You)?
ATR, or Average True Range, measures market volatility by averaging the true range of a stock over a certain period. The true range is the greatest of three values: the difference between today’s high and low, the difference between today’s high and yesterday’s close, and the difference between today’s low and yesterday’s close. Using ATR when trading options can give you a great edge over most market players.
ATR provides insights into how much a stock typically moves within a given period. A high ATR indicates significant market volatility, suggesting larger price swings, while a low ATR points to smaller movements and less volatility.
Our Intuition on ATR
Before writing about options and creating an options screener such as ours, we have been trading options for years (and still do). By this we mean to say that, when we backtest a strategy, we use it ourselves and then share it with you. So here is the idea we had about ATR.
ATR helps reveal the significance of market movements. When a stock moves up or down by 1 ATR daily, it shows a regular upward or downward movement. If you were able to spot an option trade that only requires the stock to move by 1 ATR to give you a nice profit, then you’d be looking at a rather good trade opportunity. This is what our scans do, and you can learn a lot by looking at the historical price movements of a stock, based on ATR.
For example, if a stock usually moves by 1 ATR every 14 days but hasn’t done so in the last 53 days, this deviation from its norm can indicate a potential trading opportunity. Such unusual movements can be crucial for identifying when to enter long call positions, for instance.
To illustrate, let’s say a stock generally moves by 1 ATR every 12 days, on average. If, over 20 days, it fails to reach this range and has been particularly quiet, the lack of movement might suggest pent-up volatility. In this scenario, buying a cheap long call could be profitable if the stock starts moving up by 1 ATR again. If the stock finally moves up by 1 ATR, the value of the long call could increase significantly, offering substantial returns. And if it doesn’t, that’s ok: if the call you bought was cheap, you will only lose a small amount of money.
Also, suppose a stock did not move up by 1 ATR for 25 consecutive days against an average of, say, 14 days. Wouldn’t it be interesting to observe what this stock did in the past every time it was on a 25-day streak without moving up by 1 ATR? You might be surprised to find out that it had a tendency to move down after such an occurrence, or maybe it moved downward (which is counter-intuitive, but it may happen). Our tool will help you analyze this and more.
Trading Long Calls with ATR
First of all, you can refer to the predefined scan called “Weekly calls that will explode in value with 1 ATR move”. This is a scan that lets you buy very short-term calls that will triple in value with 1 ATR move. Notice that the scan only looks for options that expire in less than a week. This is a fast turnaround and highly leveraged strategy.
Predicting how likely a stock price is to go up by 1 ATR within Friday is a huge challenge. However, if you buy relatively cheap calls, your risk will always be low, and you could likely afford to add a trade like this to your balanced portfolio.
However, we believe we have found a way to gain an edge over the market when evaluating this type of trade. As we mentioned above, a statistical study on ATR can be a huge help. If you can determine whether a stock is more or less likely to move up by 1 ATR within the next days, and this determination is based on a study of past data, you will have gained an edge.
So, let us look at a specific case. Tripadvisor (TRIP) is a stock currently trading at $17.89. If you refer to the Colab file we have designed for you (and that you can access for free), you could use the following input:
Consider that you have these fields:
- ticker: just enter the ticker you want to analyze
- start_year: you can choose the starting year of your analysis. For instance, you may want to limit your analysis to the post-Covid era by entering “2021,” but this is up to you
- end_year: here, you can choose whether to limit your analysis on the upper side or to just keep the latest available data (in this case, you’ll use “Latest” as a value)
- analysis_days: if you’re looking to invest in options expiring every Friday, you could choose to limit your analysis to 5 days. Feel free to change this number based on the expiration date of the option trade you have in mind. In short, this number should correspond, give or take, to the days to the expiration of your options.
- ATR_type: this is just a dropdown menu that lets you limit your analysis to either the +1 ATR case (“Up”), the -1 ATR case (“Down”), or both scenarios (“Both”).
Note that you can vary the length of your study (but we strongly recommend limiting the end_year value to “Latest” if you want to use the latest available data from Yahoo! Finance. At most, you can vary the beginning year of the analysis with the variable start_year).
Let us keep the number of days for the analysis equal to 5 (we will trade options expiring on Friday, so that is sufficient). Since we’re looking for long calls with underlying stocks that have not moved up by 1 ATR in a long time, we will set ATR_type to “Up.”
Once you run the whole script (just click on “Runtime” and then “Run all”), you will get a specific output (a table and two charts). Let’s comment on the table before, as it should be the first thing you look at:
There are several columns here, but you will mostly need to focus on the second row:
- Days: Here you find the total days of the analysis (first row) versus the number of days in which the TRIP price moved up by 1 ATR.
- %: Here, you have the same values as the previous column but expressed as a percentage of the total days in the analysis (so, in this case, TRIP moved up by 1 ATR on 6.77% of the days in the dataset).
- ATR $: This tells you the average dollar value of the ATR move. TRIP generally moves up by $1.29 to reach the +1 ATR threshold.
- ATR %: As you may guess, this column simply expresses the average percentage change in TRIP price corresponding to +1 ATR.
- Average days between events: This is where things get interesting. The table tells you that, on average, TRIP moves up or down by 1 ATR every 7.32 days. Since we’re trading the up case, it is more interesting to look at the second row: TRIP price generally moves up by 1 ATR every 14.77 days.
- 75% percentile: To give you a better way to spot stocks that have not moved up by 1 ATR in a long time, we have added the percentile analysis on the number of days mentioned earlier. In other words, if we find a moment in which the TRIP price has not moved up by 1 ATR in at least 27 days, we’ll be confident in saying that the stock price is close to making this move. This is not a 100% success rule, of course. It is just pure common sense derived from statistics.
Now, as you can see at the bottom of the table, there’s a little sentence that says, “Days since last upward move by 1 ATR.” For TRIP, at the moment of the analysis, this value was 28, well above the average of 14.77 days and even higher than the 75% percentile of 27 days.
You can even visualize this on a simple price chart:
This is a really easy chart to read: you have the historical close price in blue and several green dots indicating the days that recorded a price change that was at least equal to +1 ATR. You can actually see that it has been a while since TRIP moved up by 1 ATR.
Finally, you could ask yourself: “What happened to TRIP stock price when it was on a 28-day streak of no +1 ATR movements in the past?”. This is perhaps the cherry on the cake of the analysis. Just take a look at the chart below:
Note that the Colab file will analyze a 28-day streak automatically, as it has found that TRIP is currently on a 28-day streak with no +1 ATR movements.
First of all, you will find in the title the number of events that have already occurred in the past. For TRIP, we’re talking about 16 times where the stock was on this +1 ATR streak.
Second, you should notice the content of the chart. The blue line is just there as a benchmark, and it tells you the average day movement of the stock price. We added two horizontal dashed lines to tell you where the +1 ATR and -1 ATR thresholds are. The red line tells you the average movement of the stock price in those 16 events, together with a 90% confidence interval (red area). Note that, while the average price did not actually move above the +1 ATR level, a significant part of its confidence interval is well above this threshold.
In other words, there is a decent likelihood that this event will occur, and that your long call will indeed be profitable. It is not guaranteed (nothing is with statistics), but this may be worth a try.
So, what could you do? Let’s go back to our predefined scan. Following the analysis above, you may use our options screener and choose to buy a $18 call expiring on Friday. Take a look at the P&L below:
In monetary terms, you’d be losing $25 if the TRIP price fails to move above the strike price by the expiration date. You will start earning money above $18.25 and, at +1 ATR from the current price, you’ll earn $56 (a +224% return). If you think that the analysis above justifies this relatively low risk, you could go for this trade.
Trading Long Puts with ATR
Now that you know how to use our Colab file, the bearish trade case will be much easier to understand and implement. First of all, you can refer to our “Weekly puts that will explode in value with 1 ATR move” predefined scan. This scan works just like its call version, but with puts.
Let’s say we are looking for a trade opportunity on QQQ, which is currently trading at $457.95. Here is what you obtain:
We don’t need to go through each column at this stage, as we have already done this in the previous example. Just focus, for the sake of our example, on the fact that QQQ normally moves down by 1 ATR every 11.67 days, with a 75% percentile of 24 days. Interestingly, 24 is exactly the number of days that passed since the last time QQQ moved down by 1 ATR, as shown below the previous table. Therefore, we passed the first test: QQQ has not moved down by 1 ATR in a relatively long time.
We always advise to visualize a stock market price before entering a trade, so here it is:
As you may guess, the red dots indicate the days in which the QQQ price moved down by at least 1 ATR. So yes, it looks like QQQ has not moved down significantly in a relatively long time.
However, you should not consider any trade before wrapping up the analysis with the usual question: what happened to QQQ the last time it was on a 24-day streak of no significant downward move?
To answer this question, you can simply refer to the chart below:
So, QQQ found itself in the current situation 11 times in the past, and its price moved, on average, lower in the five following days. Note that the average price change failed to move down by 1 ATR, but its confidence interval shows that there’s a decent chance this may happen (or, rather, that it has already happened in the past).
Does this analysis justify the trade? We’d be less sure compared to the long call example, as the portion of the confidence interval below the -1 ATR threshold is rather small, but it can be worth a try if you find a low-risk (meaning low-loss) put contract.
For instance, you could buy a $455 put expiring on Friday with the following P&L profile:
In this case, you’d lose $45 if QQQ remained above $455 by Friday, and you’d reach a breakeven level at $454.52. At -1 ATR ($452.62), your profits would be $196, a nice +466.67% return. Considering the analysis above, it may seem like a good trade opportunity to consider.
Trading Iron Condors with ATR
If you don’t like the idea of directional trades (such as the long call and long put ones mentioned above), there are ways to use our ATR backtesting for other strategies. Take, for instance, the iron condor. The iron condor is a popular options trading strategy that involves selling both a call spread and put spread on the same underlying asset, with the same expiration date but different strike prices. This strategy profits from range-bound markets where the price of the underlying asset remains within a specific range.
The intuition here is that a stock that has recently experienced both a +1 ATR and a -1 ATR movement is likely to experience less volatility in the near future. It will not work for every stock, but that’s what a backtest is for: you run an analysis, and you carefully choose the stocks that it seems to work well for.
Our “Iron Condors With Profit Zone Within +1/-1 ATR on S&P 500” scan lets you screen for stocks and ETFs that will have their breakeven points at least one ATR away from the current price. Let’s look, for instance, at the ADSK stock, currently trading at $214.89.
Note that, in this case, the “ATR_type” value will be set to “both,” as we want to assess both +1 ATR and -1 ATR movements. Here is the table you could obtain:
Note that ADSK moved down by 1 ATR only one day ago, while it moved up by 1 ATR 9 days ago. On average, you can expect an ATR movement to occur every 6.79 days, so the next few days should be relatively safe for an iron condor. As you see from the historical price of ADSK below, the red and green dots have indeed appeared rather recently:
Just like we did before, you can also look at the average price behavior on similar occasions in the past. If we look at the 9-day streak of no +1 ATR movement, we get a relatively stable average movement in ADSK:
The same goes for 1-day streaks of no -1 ATR movement:
Therefore, maybe an iron condor is the way to go here. How would you do it? Well, our options screener would show you the possibility to do the following:
- You buy a $205 put
- You sell a $212.5 put
- You sell a $220 call
- You buy a $240 call. All the contracts should expire on the same day, this Friday.
Here is what your P&L profile would look like:
To earn a profit, you want the stock price to remain between $207.68 and $224.82 by Friday. Below the lower breakeven point, you could end up losing $267.50, and above the higher breakeven price, you would lose $517.50. Between these prices, your maximum profit will be $482.50.
If you trust all the analysis above and believe that ADSK will indeed remain within the expected range, then an iron condor could be a profitable strategy for you. However, it is important to note that this is just one possible trade using our ATR backtesting tool. It is always recommended that you do your own research and analysis before making any trades in the stock market.
Run Your Own Backtest
If you enjoyed the examples in our article and want to run your own backtests on various tickers, you can easily use our Google Colab notebook. Just make a copy and modify the parameters to your preference.
For quick access to all necessary resources, we’ve included a few links below:
