How to calculate and use average true range (ATR): Example, limitations, and FAQs

How to Calculate and Use Average True Range (ATR)

Introduction

In trading, one of the most important factors that traders pay attention to is volatility – the degree of price fluctuations in a particular market within a certain period. 

Traders have to determine how much an asset is going to move in order to effectively manage risk and make good decisions. 

The Average True Range (ATR), developed by J. Welles Wilder, is one of the most popular volatility indicators that can be used to measure market volatility.

ATR is a very effective tool in technical analysis, for it gives information on the amount of price movement on an asset regardless of direction. 

It does not necessarily tell whether prices will move up or down but does inform traders about the actual magnitude of price movement so they can adjust their strategies on that basis. The ATR can be used in both stocks, commodities, and currencies across all markets.

This article elaborates on the computation of ATR, how it should be used in trading, the limitations, and provides an example in detail.

What is Average True Range (ATR)?

Average True Range (ATR) is a measure of volatility of the market. Unlike any other indicator that is mainly centred around price direction, 

ATR takes care of how much the price moved during a given time frame only. The ATR is calculated by taking the average of the “True Range” over a given period of days, which is normally 14 days. 

True Range is derived by taking three major factors: the current high and low prices and the difference between the previous close and the current high or low.

Since ATR is expressed in the same unit as the price, it can be directly applied to a range of markets, regardless of the fact that the price might be in dollars, euros, or any other currency or unit. 

It informs the trader of the level of price volatility, which remains one of the critical components for defining trading strategies, the stop-loss orders, and risk management.

How to Calculate ATR?

To find ATR, several steps need to be followed. Let us take this step by step

Step 1: Calculate the True Range (TR)

The True Range (TR) is the greatest between the following three values:

1. Current High minus Current Low: This refers to the range for the current trading period.
2. Current High minus Previous Close: This value accounts for any gaps that could have occurred between the previous close and the current period’s high
3. Current Low minus Previous Close: Similar to the previous value, this value accounts for the gaps between the previous close and the low of the current period

The formula for the True Range is as follows:

TR=max( High_t − Low_t ,∣ High_t – Close_t – 1 ∣, ∣ Low_t – Close_t – 1 ∣ )

Step 2: Calculate the Average True Range (ATR)

Once you have the True Range for each period (for instance, 14 periods), the ATR is calculated by averaging the True Range values over the desired period. The most common period used is 14 days.

The formula for ATR is:

Where:

• TRi is the True Range for each period,
• n is the number of periods (commonly 14).

Let’s now explore a practical example to understand the calculation better.

Example: Calculating ATR

Let’s use a simple example to demonstrate how to calculate ATR over a 3-day period.

Step 1: Calculate the True Range (TR)

• Day 1:
  • TR = max(10.5 – 9.8, |10.5 – 10.0|, |9.8 – 10.0|) = max(0.7, 0.5, 0.2) = 0.7
• Day 2:
  • TR = max(11.0 – 9.9, |11.0 – 10.5|, |9.9 – 10.5|) = max(1.1, 0.5, 0.6) = 1.1
• Day 3:
  • TR = max(10.8 – 9.6, |10.8 – 11.0|, |9.6 – 11.0|) = max(1.2, 0.2, 1.4) = 1.4

Step 2: Calculate the Average True Range (ATR)

Now, we calculate the ATR as the average of the True Ranges over the 3-day period:

So, the ATR for this period is 1.07. For a 14-day ATR, you would repeat this process for 14 periods and take the average.

Uses of ATR in Trading

Even though ATR doesn’t point out the direction of the market, it does aid traders in a few aspects.

1. Assessing Market Volatility: In that regard, ATR is helpful in measuring the volatility of a market. Higher ATR points to increasing market volatility and vice versa. The fluctuations in ATR could be monitored to give an idea of how market conditions are.
2. Stop-Loss and Take-Profit Orders: ATR is applied widely to set more dynamic stop-loss and take-profit orders. Trader can place stop-loss orders at a multiple of ATR below the entry price. It allows traders to absorb natural price swings while preventing the larger moves that will undo them.
3. Position Sizing: ATR also helps in position sizing. If it is a volatile market with higher ATR, then the trader may increase his position size to reduce the risk. If ATR is less, then the position size can be increased.
4. Trend Confirmation: Confirm trend with ATR. If price is trending up and ATR also increases, this suggests a trend sustained by increasing volatility; that is, it is a good trend. If ATR decreases, then perhaps it’s time to suspect that the trend has weakened.
5. Identifying Market Breakouts: A spurt in ATR can indicate that the market is breaking out. This often happens when the price is moving sharply in either direction, which may be an indication of a trading opportunity.

Limitations of ATR

Though ATR is very popular, it has several disadvantages:

1. Does Not Indicate Price Direction: ATR measures volatility but does not provide any direction on price movement. Other indicators like moving averages or RSI have to be used in establishing the market’s direction
2. Sensitivity to Gaps: ATR is sensitive to gaps between trading sessions. At times, it causes ATR values to shoot up needlessly and does not portray the real underlying market volatility.
3. Does Not Account for Fundamental Factors: ATR is a technical indicator and, hence, does not take into consideration any external factors that could impact volatility such as news events, economic reports, or geopolitical issues
4. Not Ideal for All Market Conditions: ATR works best on smooth-moving markets. For markets with sideways or range-bound prices, ATR does not really have much to offer as the range could be tight with not much volatility going on.
   Conclusion:

Conclusion

It offers Average True Range, which is important in the assessment of market volatility. 

As a measure of price range fluctuations, it enables traders to understand prevailing market conditions and make smarter, more dynamic stop-loss entry adjustments, hence making better judgments to trade. 

While ATR may present limitations, it is essentially an important tool for many traders in gauging market volatility and adjusting accordingly.

Proper application of ATR should always be coupled with other technical indicators and risk management tools. 

Knowing how to interpret the values of ATR in different market conditions will lead to more prudent decisions, reduce potential risks, and increase trading opportunities.

FAQs

1. How to Compute ATR (Average True Range)

A technical indicator in measuring market volatility is known as Average True Range. In order to calculate ATR, the steps given below should be followed.
Step 1: Calculate the True Range
•Current High :Current Low; That’s the difference between the highest and lowest prices during the current period.
•Absolute value of the Current High minus the Previous Close: Absolute difference between the highest price in the current period and the close in the previous period.
•Absolute value of the Current Low minus the Previous Close: Absolute difference between the lowest price in the current period and the close in the previous period.

This would leave the True Range, that would include any price gaps between closing in one period and the highest or lowest of the other period.

Step 2: Calculate the ATR

Once you have the True Range for each period, you can calculate the ATR by averaging the True Range over a specified number of periods (usually 14). The formula for ATR is:

Where:

TRi is the True Range for each period.

n represents the number of periods (traditionally 14 for most calculations of standard ATR).

ATR is typically a line appearing on a chart used for measuring the asset’s volatility.

2. How Do You Use a True Range Indicator?

The True Range indicator computes the overall volatility of the market. It calculates the difference of high and low prices adjusted for the possibility of gaps happening in price. Here is how it may be used effectively:

•Risk Management: True Range enables the understanding of the possible magnitude of moves, which is required for placing stop-loss orders. 

The higher the True Range is, the higher the market volatility would be and give room to place stop-loss orders while leaving it sufficient breathing space without putting their positions in danger.

•Breakout Identification: This extreme True Range spike could be a breakout and even sign of a trend change. For break-out traders, this is useful because always, after an extreme True Range rise, there is a great price move.

• Trend Confirmation: In trending markets, increasing True Range during the uptrend means the market is becoming more volatile; thus, it would tend to sustain the trend. The market will probably continue its lower movement in a downtrend.

In one word, the True Range may be used for volatility assessment in the market, modulation of risk levels, and breakout level identification.

3. How to Use Average Daily Range Indicator?

It helps a trader make sense of the average price swing of an asset throughout the course of a trading day. To use the ADR effectively:

•Target Points: ADR gives a rough estimate of how much an asset would move in a day. This information can be used by traders to set price targets realistically. 

For example, if the ADR for a stock is $2, it means that the stock moves approximately $2 each day. This will be helpful for traders to set entry and exit points considering price movements.

• Intraday Stop-Loss and Take-Profit Levels: ADR is used by traders to set the right stop-loss and take-profit levels. 

They can place their stop-loss orders at a distance which accommodates usual price movement by considering average daily price movement, thereby not getting stopped out too early. 

They can also set the take-profits at appropriate levels for the average movement to achieve realistic targets, considering normal volatility of the asset.

• Market Volatility Assessment: Higher ADR implies that volatility movement experienced by the asset.

Therefore, this particular asset is very likely to be swung by huge intraday moves, or simply conversely, a lower ADR suggests a very stable market with the price staying within its range bound and may not create some serious intraday moves for traders; 

so they would end up by using an apt range trading or breakout strategy for their trades.

4. What is the Best Average True Range Setting?

ATR Best settings will depend on your strategy in trading, the type of assets and time horizon. The period at default for ATR is typically 14 days, but most of the traders modify that to suit their needs.

• Less Periods (e.g.7): The volatilities tend to respond to smaller shifts of low ATR periods, and in addition, may be applied very well to intraday as well as shorter period trading. 

Users who employ day trading and scalping may feel that it is perfect using a 7-period ATR through which they will be ultra-responsive towards sudden shifts of major volatility directions.

• Longer Periods (e.g., 21 or 50): The higher ATR value smooths the volatility, which then gives a clearer view of the long-term trends. 

Normally, swing traders or long-term investors make use of the longer ATR settings since they have to filter out the noise of daily price fluctuations and focus on more significant volatility trends.

• Default Setting (14): The setting for A14-period ATR balances its response toward the changes of the market and provides a relatively smooth view of volatility. 

It is one of the most frequently used settings and is mainly applied to different timeframes and conditions of the market.

Ultimately, the best ATR setting will depend on your trading style, the asset class, and the market volatility in which you trade. 

You can fine-tune it for better fit with the conditions of the market you are analysing.

5. How to Use ATR in Intraday Trading?

In intraday, ATR is absolutely essential for managing risks and also for setting entries and exits. So, using ATR in intraday trading:

•Stop-Loss Placement: ATR may be used in determining how far a stop-loss order should be placed. This is so because ATR measures market volatility. 

Therefore, a trader may use 1.5 or 2 times the ATR from the entry price to determine where to position the stop-loss. 

He may place the stop-loss more distant if the ATR is large to avoid stop-outs due to regular price action.

• Position Sizing: Traders may use ATR to position-size themselves. High ATR values denote high volatility, hence the need for smaller position sizes and vice versa; 

that is when ATR values are low and volatility low, traders could increase the size of their position because price movement is going to be minimal against the trader’s direction.

•Trade Timing: ATR can also guide traders when to enter or exit trades. When ATR rises it indicates a rise in volatility and there is the likelihood that the market would prepare for more significant moves.

A steep jump in ATR may indicate that either a break out or a more meaningful price action should be expected and traders take this cue as an entry or exit position.

6. How to Use ATR for Take Profit?

This could be a way of setting realistic take-profits, because then the expectation of gains is based on real market volatility. Here’s how:

•Targeting Profits: ATR can be used for setting a take-profit level multiple ATR away from entry price. For example, if the ATR is 2 for the particular asset. Suppose a trader enters into a position with a price of $100, then the take profit target can be set at two times ATR from the price. This would be placed at $104. As a result, the target of this trade is sure to sound rational in terms of historical price movement from an asset.

•Dynamic Take-Profit: ATR is dynamic and depends on the market. Traders can adjust their take-profit targets as ATR increases or decreases. Thus, if ATR increases, the trader may extend their take-profit target to accommodate larger potential moves. Conversely, if ATR lowers, the trader may scale down their target to align with the lower volatility.

•Risk-to Reward: The tool also shows how an efficient ATR will create for a trader a fine-looking risk-to-reward. For instance, supposing a trader has applied his stop-loss at 1.5 times the ATR but calculates take profit at 3 times ATR. He benefits here from the 2:1 ratio of risk to reward. By relating stops and takes with ATR, there will definitely be correct sizing up by a trader of both the reward as well as risk depending upon market conditions’ intensity.