Average True Range (ATR) is the most commonly used volatility indicators within technical analysis. ATR, one of J. Welles Wilder’s best ideas in his book New Concepts in Technical Trading Systems, delivers insights into market volatility.
Therefore, traders can better evaluate their decisions about entering, adjusting, or leaving the trades. Unlike other indicators that try to reflect the trend or momentum of price movement, ATR relies solely on the fluctuation of prices in any direction. This makes it a very useful indicator in any market condition.
In this text, we will describe how to calculate and use ATR, provide a practical example on how to apply ATR, and outline limitations and best use cases.
What is Average True Range?
Average True Range is the measure of asset volatility for a given number of periods. It can be 14 periods, and was originally created as a market volatility indicator in commodities. It’s used in all asset classes now, including stocks, forex, and cryptocurrencies.
ATR is very useful in establishing the amount of price movement and the size of how much an asset moves over a period of time. Note that ATR does not care about the direction of the price movement but about the magnitude of that movement. The higher the ATR values, the higher the volatility, and the lower the ATR values, the lower the volatility.
How to Compute Average True Range (ATR)
To calculate the Average True Range (ATR), you first have to find the True Range (TR) for each period of the series of prices that you are evaluating. The True Range is the maximum of the three of the following values: Current High – Current Low Current High – Previous Close (absolute value) Current Low – Previous Close (absolute value)
Once the True Range for each period has been calculated, the Average True Range is just an average of those values over a number of periods typically set at 14.
Step-by-Step Calculation of ATR
Determine the True Range (TR) for each period:
The first True Range is the absolute value of the difference between the highest and lowest prices of the first period.
For each subsequent period, calculate the True Range using the three values outlined earlier and pick the highest value.
Example for a single period:
Current high =$145
Current low = $140
Previous close =$142
The three calculations would be:
Current High – Current Low = 145 – 140 = 5
Current High – Previous Close = 145 – 142 = 3
Current Low – Previous Close = 140 – 142 = -2 (absolute value = 2)
The True Range for this time period is 5 because it is the largest of the three.
Average True Range over a time period:
For the first period, just use the True Range value.
For subsequent periods, average the True Range values.
ATR is usually calculated over 14 periods. To calculate ATR, you add up the True Ranges for the last 14 periods and divide by 14.
Formula for ATR:
ATR =
Where:
- TRi = True Range for each period
- n = number of periods (typically 14)
How to Apply Average True Range
The primary application of ATR is the measure of volatility. Its applications are segmented into the following areas:
1. Position Sizing and Risk Management
Traders often use this to determine how much risk they are willing to take on a trade and therefore how large the position will be. The ATR value can be used by the trader to set a stop-loss that is appropriate for the asset’s volatility.
For instance, if an asset has an ATR of 2 points, a trader may then set the stop-loss at 2 ATRs away from their entry price. If trading a $100 stock, for example, a trader may place their stop-loss at $96 if they are trading the asset with a 2 ATR value.
This helps ensure that the trader does not take a position that is too large relative to the volatility of the asset, which can protect the trader from excessive risk.
2. Setting Stop-Loss Orders
ATR is often used in placing stop-loss orders. With ATR, you will be able to place a stop-loss that accounts for the natural volatility of the asset instead of using arbitrary or fixed amounts.
For example, if the price of a stock is trading at $150 and the ATR is 3, then the trader would put the stop-loss at $144, calculated by (150 – 3 * 2 = 144). This allows the price to move without hitting the stop-loss too early due to short-term market noise.
3. Trend Confirmation
ATR can also be employed as a confirmation tool when trying to decide if a market is trending or ranging. If the ATR is rising, then it indicates that the market is becoming even more volatile, which means that something is forming.
If ATR is falling, that may indicate that market volatility has been subsiding, that could mean consolidation or it could be a range-bound market.
4. Breakout Trading
Traders often use ATR for breakout positions. When the price of any asset breaks out from a range or pattern, an increased ATR accompanies that move. This means the breakout has strength and possibly may continue in that direction.
Limitations of ATR
A simple tool, however, ATR has its limitations. Traders must be aware of these constraints to prevent overutilization of the indicator.
1. No Directional Information
ATR measures volatility but shows no directional implication on price movement. A higher value of ATR may also signify a strong price movement up or down or could be wildly swinging within a limited range. In this sense, ATR should not be used solely as it should be utilized in tandem with other indicators, such as moving averages, or even momentum indicators.
2. Lagging Indicator
Like most technical indicators, ATR is a lagging indicator. It relies on past price action and, therefore, may not be timely in terms of sudden changes in volatility. In volatile markets, ATR may not immediately respond to an abrupt increase or decrease in volatility.
3. Not Meant for Price Movement Predictions
ATR measures volatility, not price movement. Using ATR, traders are not in a position to foretell when prices will go either upwards or downwards. Increasing ATR simply means that the volatilities are increasing; therefore it gives no direction for making any trades.
4. Deceives during Market Gaps
If a stock or asset has a gap in price (i.e., when the close of one period is very different from the open of the next), the ATR can be deceiving. In such cases, the True Range calculation may overstate volatility because the gap will be included in the ATR computation.
Summary
ATR (Average True Range) is a sort of volatility indicator developed by J. Welles Wilder. It calculates the amount of price movement during a period, normally 14. Unlike the majority of technical indicators, the ATR does not describe any direction to which the price is supposed to go, but gives purely the magnitudes that price moved.
The ATR calculation starts with finding the True Range for every period, which is computed based on the current high, low, and previous close. Then it is averaged over the chosen period. ATR is widely applied in risk management and position sizing because this indicator helps traders determine stop-loss orders based on an asset’s volatility.
This ensures that positions are sized according to market conditions. Confirm Trends- Another application of ATR is to confirm the trend. An increasing ATR value suggests a reflection of increasing volatility and even indicates possible trends in the markets.
But ATR also carries along few negatives like this is a lagging indicator that does not provide directional insight, which may also be misleading in highly volatile markets like in the case of price gaps. Although it measures past action of price, it cannot predict future price movement, and with other technical indicators, its potential is maximized.
Overall, ATR proves helpful for understanding market volatility and, while it should be used together with other analyses, really helps in making better trading decisions.
Conclusion
Another major volatility measuring tool in the market is the Average True Range, ATR. It is used to gather information regarding price movement that may eventually be used in risk management, position sizing, and stop-loss levels determination.
With the knowledge of how to compute ATR and how it might be combined with other technical indicators, traders would be well-equipped to make better decisions and ride the waves of volatile markets more effectively.
Still, ATR has its limitation. It’s not a good direction of signal and based upon historical price action. In other words, it may therefore be great at forecasting what in reality happens in the future when combined with more detailed analysis techniques and applications for trading strategy.