Average True Range

What is the Average True Range (ATR?)

Average True Range (ATR) is the average of true ranges over the specified period and it measures the volatility taking in to account any gaps in the price movement. ATR calculation is based on 14 periods and it can be intraday, daily, weekly or monthly.  ATR was developed by J Welles Wilder. As most of his indicators Wilder designed ATR with commodities and daily prices in mind.  Commodities are more volatile than stocks. They are often subject to gaps or limit moves which occur when the commodity opens up or down its maximum.  A volatility formula which is based only on the high low range would fail. Wilder created Average True Range to capture this missing volatility.

The Average True Range (ATR) Formula                                           

ATR = (Previous ATR * (n – 1) + TR) / n

Where:

ATR = Average True Range
n = number of periods or bars
TR = True Range

The True Range for today is the greatest of the following:

• Today’s high minus today’s low
• The absolute value of today’s high minus yesterday’s close
• The absolute value of today’s low minus yesterday’s close

How to calculate the ATR

The calculation of ATR range is 14-period based. The period can be intraday, daily, weekly or monthly. Since true range and ATR are calculated by subtracting prices, the volatility they compute does not change when historical price are adjusted back by adding or subtracting constant to every price. 

The average true return calculation is relatively simple. The ATR moves up and down as the price movement becomes larger or smaller. ATR uses historical price data as soon as the new time period passes it generates a new value.

To calculate the current average true range, you need to calculate the prior ATR and current TR. The current TR is the highest number of three true ranges (TRs) calculated as follows:           

1. Current high minus current low.
2. Current high minus the previous period’s close.
3. Current low minus the previous period’s close.

As for prior ATR in stock market , if you analyse a 14-day period, you calculate the prior ATR from the highest values for each day, adding together the highest values and dividing the total by 1/n, with “n” representing the number of periods, so in this case, it is 1/14. Once you have the TR and prior ATR, you calculate the current ATR from Wilder’s formula to smooth out the data with a moving average.

The ATR  Indicator  formula is outlined below:

Current ATR = ((Prior ATR x 13) + Current TR) / 14

What does the ATR Indicator Tell You

Wilder had developed ATR for the commodities although the indicator can be used for stocks and indices also. ATR indicator maybe used for market technicians to enter and exit trades and is useful tool to add to a trading system. It was created to allow traders to more accurately measure the daily volatility. The indicator does not indicate the price direction. It is used primarily to measure volatility caused by gaps and limit up or down moves. The ATR is relatively simple to calculate.

The ATR is commonly used as an exit method that can be applied.  The ATR indicator can also give a trader an indication of what size trade to use in the derivatives markets.

In simple terms a stock with a high level of volatility has a higher Average True Range and similarly a stock with a lower volatility has a lower Average True Range. Traders use the indicator to enter and exit trades and also they put a stop loss in order to reduce the loss. 

Advantages of the ATR

ATRs are in some ways superior to using a fixed percentage because they change based on the characteristics of the stock being traded recognizing that volatility varies with various issues and market conditions.  The ATR is so important because it offers the trader a sense of how volatile market is. Also the information is based on solid trading strategy, the trader can have a competitive advantage in front of the other traders.

It is important to understand that Average True Range can be used as a filter to do trades in good locations. It is a powerful tool for defining stop loss levels and profit targets. Average True Range is helpful indicator to find high probability trades and have efficient trade management.  For day traders whose executions are on the 5 minute and 15 minute chart the ideal ATR should be daily average true range to have a reference of the levels. Whereas ATR for swing traders should be weekly and monthly average true range as the main references because the holding period of the position is longer.

The correct use of the ATR must be done with a solid trading plan, proper risk management, and specific trading criteria.  ATR along with other technical indicators and market context helps to validate the position in the market.

Limitations of the ATR Trading

The limitations of the ATR Trading are mentioned below

1. ATR Trading only measures volatility and not the direction of the price trend which can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points.
2. ATR Trading is a subjective measure. There is no reference point telling you whether the current market is volatile or not. ATR should always be compared against earlier values to get a feel of a trend’s strength or weakness.

Conclusion

The average true range is a straightforward technical indicator used to determine price volatility. A good ATR depends upon the asset. It is best used to determine how much investment price has been moving in the period being evaluated rather than an indication of a trend. Calculating an investment’s ATR is relatively straightforward only requiring to use price data for the period of investigation.

Traders use it in forex. Stock, index, ETF and cryptocurrency trading to measure how much an asset has moved during a specific period.  Traders usually prefer   to use it with other technical indicators as it is an aid to decide when to buy and sell.