Average True Range or ATR is a technical analysis indicator that decomposes the whole range of an asset price for a particular period and measures the market volatility for that period. On average, 14-day periods are used to generate trading signals based on the simple moving average of a series of accurate range indicators.
What is Average True Range?
ATR or Average True Range was introduced by J. Welles Wilder Jr., a market technician. ATR was originally created to analyze commodities. But, it is also being used to analyze indices and stocks in the current scenario. Traders are using ATR to decide when to enter and exit trades. It is a valuable addition to any trading set-up.
The indicator for the true range is the highest of the following:
- Current high minus the current low
- The absolute value of the current high minus the previous close
- The absolute value of the current low minus the previous close
A moving average of the true ranges for a period of 14 days is then taken as the ATR.
The formula used to calculate the Average True Range
To calculate the ATR, finding a series of true ranges for security is the first step. The true range is given as follows:
TR = Max[H – L], Abs(H – CP), Abs(L – CP)
ATR = (1/n) i=1nTRi
Here,
- TRi = A particular true range
- n = The time period considered
How is ATR calculated?
Noting that 14-day periods are used to generate trading signals, longer periods tend to generate fewer signals while shorter periods will provide a higher number of trading signals. For instance, if a trader wants to find out the volatility of stock for a short period of time of 6 trading days, they can calculate the ATR for 6 days.
If the historical price information is arranged chronologically in reverse, the trader will identify the maximum of the absolute value of the current high and reduce the current low, the absolute value of the current high reduced by the previous close, and the absolute value of the current low reduced by the previous close. The true range calculations will be done for the six recent trading days. The average of these will then be taken to calculate the first value of the six-day ATR.
What can you tell from the Average True Range?
When used in a trading system, the ATR helps traders accurately analyze the volatility of stocks using very simple calculations. The higher the ATR, the higher the volatility of the stock, and the lower the ATR, the lower its volatility.
It does not give the direction in which the price of the concerned stocks will move but measures the volatility caused due to up and down moves. To do this, all it needs is the data regarding the historical prices of the stocks.
The ATR is regularly used to exit trades and it can be applied regardless of how the decision to enter the trade is made. The “chandelier exit” is a common technique used in this regard. It was developed by Chuck LeBeau. Under this method, a trailing stop is placed below the highest high reached by the stock since the trade was entered into. The gap between the stop level and the maximum high is defined as multiple times the ATR.
The ATR is also used to offer traders an idea of what the size of their trade must be in the derivatives market. The ATR method can be used to position sizing that will account for an individual trader’s acceptance of risk on their own along with the respective market’s volatility.
Limitations
Adopting the ATR indicator has two major limitations. First, ATR can be interpreted in different ways since it is a subjective measure. There is no particular ATR value that can say with absolute certainty whether a trend will reverse or not. It is always advisable to compare the calculated ATR values with readings taken before to identify whether a trend is going to get stronger or weaker.
Another limitation is that ATR does not measure the direction in which an asset’s price will move but measures only its volatility. Due to this, when trends are at turning points or if the market is going through pivots, ATR may give mixed indications.
