Average true range (ATR)

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Average true range (ATR) is a volatility indicator that shows how much an asset moves, on average, during a given time frame. The indicator can help day traders confirm when they might want to initiate a trade, and it can be used to determine the placement of a stop-loss order.

ATR was introduced by market technician J. Welles Wilder in his book New Concepts in Technical Trading Systems, that measures market volatility by decomposing the entire range of an asset price for that period.

The ATR indicator moves up and down as price moves in an asset become larger or smaller. A new ATR reading is calculated as each time period passes. On a one-minute chart, a new ATR reading is calculated every minute. On a daily chart, a new ATR is calculated every day. All these readings are plotted to form a continuous line, so traders can see how volatility has changed over time.

How to calculate ATR: To calculate the ATR by hand, you must first calculate a series of true ranges (TRs). The TR for a given trading period is the greatest of the following:

  • Current high minus the previous close
  • Current low minus the previous close
  • Current high minus the current low

Whether the number is positive or negative doesn’t matter. The highest absolute value is used in the calculation. The values are recorded for each period, and then an average is taken. Typically, the number of periods used in the calculation is 14.

Subsequent ATR values are calculated using the following formula after initial 14 period ATR are calculated.

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

How ATR can help in trading decisions?

Day traders can use information on how much an asset typically moves in a certain period for plotting profit targets and determining whether to attempt a trade.

Wilder originally developed the ATR for commodities, although the indicator can also be used for stocks and indices. Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR.

The ATR may be used by market technicians to enter and exit trades, and is a useful tool to add to a trading system. It was created to allow traders to more accurately measure the daily volatility of an asset by using simple calculations. The indicator does not indicate the price direction; rather it is used primarily to measure volatility caused by gaps and limit up or down moves.

Volatility is an important concept in the financial market which indicates the degree of movement of financial assets within a certain period of time. For example, assets like Bitcoin and Ether are more volatile because their prices can rise and drop by more than 5% within a session. On the other hand, some stocks like Berkshire Hathaway are not volatile since they don’t move significantly in a session.

Long-term investors make most of their money when a stock is rising slowly over a long period of time. As such, they are not fond of volatility. On the other hand, day traders love volatility because of the significant opportunities it creates.

A good example is what happened during the coronavirus pandemic in 2020. Since there was a lot of volatility, many investment banks and hedge funds that have large trading accounts generated billions of dollars.

Therefore, the Average True Range (ATR) can tell you whether there is volatility or not. Other indicators that show or measure volatility are Bollinger Bands, historic volatility, Donchian channels, and the relative volatility index.

HOW TO READ (AND USE) THE ATR: The ATR is an indicator that is significantly different from other indicators we have covered. This is because it is not used entirely to predict where the asset is moving. It is also not used to show whether an asset is overbought or oversold.

Instead, it is used to show whether there is volatility in the market or not.

So, how do you use the Average True Range?

When the market is consolidating, the ATR usually shows no major moves. This is because there is no volatility. If the price breaks out and starts moving lower, you can use the ATR to validate whether there is enthusiasm in the market about it.

Momentum vs Volatility: The ATR indicator measures volatility. Traders often mistakenly believe that volatility equals bullishness or bearishness. Volatility does not say anything about the trend strength or the trend direction, but it tells you how much price fluctuates.

Volatility = How much price fluctuates around the average price. In a high volatility environment, price candles usually have long wicks, you can see a mix of bearish and bullish candles, and their candle body is relatively small compared to the wicks.

Momentum = Momentum is the exact opposite. Momentum describes the trend strength into one direction. In a high momentum environment, you typically see only one colour of candles (very few candles moving against the trend) and small candle wicks.

Limitations of the Average True Range (ATR):

There are two main limitations to using the ATR indicator. The first is that ATR is a subjective measure, meaning that it is open to interpretation. There is no single ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead, ATR readings should always be compared against earlier readings to get a feel of a trend’s strength or weakness.

Second, ATR only measures volatility and not the direction of an asset’s price. This can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points. For instance, a sudden increase in the ATR following a large move counter to the prevailing trend may lead some traders to think the ATR is confirming the old trend; however, this may not actually be the case.

 

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