What is an Average True Range (ATR) indicator?
The Average True Range (ATR) is one of the most popular and widely-used technical analysis indicators, it tracks the volatility of a particular market. Unlike numerous other technical indicators, the ATR does not indicate the market’s price trend, measuring only the degree of its volatility.
Originally introduced for use in commodities markets, it has been applied to all types of securities ever since. Today, the Average True Range may help traders confirm when to start a trade and to define where to set a stop loss and take profit orders.
The ATR indicator represents an N-period smoothed moving average (SMMA) of the true range values. A 14-period smoothing was originally recommended by J. Welles Wilder.
If you would like to know how to read the ATR indicator, watch a short video about using the Average True Range technical analysis method in your ATR indicator strategy.
Who invented the Average True Range (ATR) indicator?
The ATR indicator, as an effective measure of market’s volatility was introduced by a famous American technical analyst J. Welles Wilder Jr. in his book “New Concepts in Technical Trading Systems” in 1978.
Wilder is the founder of several highly important technical indicators, now regarded as the core technical analysis tools in trading. Besides the Average True Range indicator, he also invented the Relative Strength Index (RSI), the Average Directional Index and the Parabolic SAR.
Although Wilder’s technical indicators were developed even before the digital age, they have withstood the time test and keep their extreme popularity among traders.
Technical Analysis: how to use the Average True Range Indicator?
To make the right trading decisions, a trader should understand how their favourite indicator is created. We’ll show you how the ATR indicator is calculated without delving deeper into math formulas.
The ATR measures how much the market’s price moves on average. It is usually worked out through one of 3 methods of defining the True Range (TR) values, depending on how the candles are formed.
- Method 1. Current high less the current low. It is used when the current candle’s range is larger than the previous candle.
- Method 2. Current high less the previous close (Absolute value). It is used when the current candle closes higher than the previous candle.
- Method 3. Current low less the previous close (Absolute value). It is used when the current candle closes lower than the previous candle.
Therefore, we may assume that the larger the range of the candles, the greater the value of the Average True Range.
Usually, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. To form the beginning, the first true range value is calculated as the high minus the low. The 14-day ATR is the average of the daily true range values for the last 14 days. The Average True Range formula looks as follows:
Why is the Average True Range strategy useful for traders?
Simply put, a stock experiencing a high level of volatility has a higher ATR, and a stock with a lower volatility has a lower ATR. Traders may use the indicator to enter and exit trades and to put a stop loss and take profit orders. The Average True Range trading strategy can be of great help when it comes to making trading decisions.
The ATR indicator is most commonly used as a stop loss tool. When the ATR is high, traders are prepared for greater volatility and wider price fluctuations. Therefore, they would set their stop loss orders further away to avoid being kicked out of the trade prematurely. Vice versa, when the ATR indicates lower volatility, traders may use a closer stop loss.
The Average True Range Indicator also helps to understand the profit potential of trades. You can place a closer take profit in a low volatility market, and make it further away, if the volatility spikes.
Based on True Ranges, which use absolute price changes, the Average True Range indicator reflects volatility as an absolute level. It means that the ATR is not reflected as a percentage of the current close. It means that high-priced stocks will have higher ATR than low-priced stocks. For example, a $400-500 stock will have higher ATR value than a $40-50 stock. Therefore, the ATR values are not comparable.
Using ATR in your trading practice, remember that it is not a directional indicator and measures only volatility. Moreover, the ATR is a subjective measure and it can’t be used as a standalone indicator, giving you some insights of whether the trend is about to reverse or not. Still, the ATR is a great tool, when it comes to adapting to ever-changing market environment.