Every trading approach should be accompanied by its personalized risk management protocol. One such protocol (or indicator) is the average true range.
The average true range (ATR) is a kind of market volatility indicator commonly used in technical analysis. The ATR indicator displays the average price variation of assets within a given period. Investors can use the indicator to determine the best time for trading during an active market session and create trading strategies for maximizing profit potential.
This article covers:
What is ATR?
J. Welles Wilder, Jr. created the Average True Range and featured it in his book New Concepts in Technical Trading Systems. The book was published in 1978 and also featured several of his now-classic indicators such as the Relative Strength Index, Average Directional Index, and the Parabolic SAR. The ATR indicator is still widely used and has great importance in the world of technical analysis.
To understand the average true range, you should first understand the concept of volatility. You cannot always measure and predict it with accuracy. Even though the concept is more essential in options trading, you need it pretty much everywhere. Traders cannot trade without volatility nor manage their positions and risk.
Fundamentally, the ATR indicator is a price volatility indicator, which means, it measures the volatility of the price of a stock within a period. This tool does not provide an indication of the price trend, rather, simply displays the degree of price volatility.
The Average True Range also takes into account the gaps in the movement of price. The ATR indicator helps traders predict how far the price of an asset may move in the future and is also useful when deciding how far away to place a stop loss or a profit target.
Typically, the average true range is an n-period-smoothed moving average of the true range values. The average true range calculation is primarily based on 14 periods, which can be intraday, daily, weekly, or monthly. To measure the latest volatility, use a shorter average, such as 2 to 10 periods. For longer-term volatility, use 20 to 50 periods.
How can ATR help in trading decisions?
Day traders can use statistics on how much an asset usually moves in a certain period for plotting profit targets and determining whether or not to strive for a trade. Assume a stock moves Rs 20-30 a day, on average. There is no significant news out, but the stock is already up to Rs 50 on the day. The trading range (high minus low) is Rs 30. The price has already moved 35% more than the average, and now you’re getting a buy signal from a strategy.
The buy signal may be valid but, since the price has already moved up significantly (more than the average), betting that the price will continue to go up and expand the range even further may be a tricky decision to make. The trade goes against the odds. The investor may conclude that the price is more likely to fall and stay within the price range already established. While buying once the price is near the top of the daily range—and the range is well beyond average—isn’t prudent, selling or shorting is probably a good option, assuming a valid sell signal occurs.
ATR trailing stop loss
A trailing stop loss is a way to exit a trade if the asset price moves against your expectation, but it also enables you to move the exit point if the price is moving in your favour. Many day-traders use the ATR indicator to figure out where to put their trailing stop loss.
At the time of a trade, look at the current ATR indicator reading. A rule of thumb is to multiply the average true range by two to determine a reasonable stop loss point. So, if you’re buying a stock, you might place a stop loss at a level twice the average true range, below the entry price. If you’re shorting a stock, you would place a stop loss at a level twice the average true range above the entry price.
Calculating ATR and its indicator
The measurement of the average true range is 14-period based. The period can be intraday, daily, weekly, or monthly. For example, a new Average True Range is calculated every day on a daily chart and every minute on a one-minute chart. When plotted, the readings from a continuous line shows the change in volatility over time.
For calculating the Average True Range, a series of true ranges needs to be calculated first. For a specific trading period, the true range is the maximum of absolute values of the following:
1. Current high – Current low
2. Current low – Previous close
3. Current high – Previous close
An average is taken for the recorded values of each period using the number of periods as 14. It gives the value of the average true range. The initial 14-period average true range value is calculated using the method explained above. For subsequent 14-period average true ranges, the following formula is used:
Current Average True Range = [(Prior Average True Range x 13) + Current True Range] / 14
Measuring the strength of a move
As previously stated, the Average True Range does not take into account price direction, therefore it is not used as an active indicator to predict future moves. Instead, it is most useful in measuring the strength of a move. For example, if a security’s price makes a move or reversal, be it bullish or bearish, there will usually be an increase in volatility. In that case, the Average True Range will be on the rise. This can be used as a way to gauge the underlying strength of the move. The more volatility in a large move, the more interest or pressure there is reinforcing that move.
On the other hand, during periods of sustained sideways movement, volatility is often low. This could assist in the discovery of trading ranges.
Using absolute value
The fact that ATR is calculated using absolute values of price differences is something that should not be ignored. This is relevant because it means that securities with higher price values will inherently have higher Average True Range values. Likewise, securities with lower price values will have lower ATR values. The consequence is that a trader cannot compare the Average True Range values of multiple securities. A trader should study and research the relevance of ATR for each security independently when performing chart analysis.
Interpreting the Average True Range Indicator
If the Average True Range is expanding, it implies increasing volatility in the market. The Average True Range is non-directional; hence, an expanding range can be an indication of either a short sale or a long buy. A sharp decline or rise results in high Average True Range values. The high values are generally not maintained for long.
A low value of the Average True Range indicates small ranges in several consecutive periods. The Average True Range values imply lower price volatility. If the Average True Range value remains low for some time, it may indicate the possibility of a trend reversal, or continuation move and an area of consolidation for the stock.
The Average True Range – an indicator of price volatility – is used for entry or stop prompts. The Average True Range stop adjusts to consolidation areas or sharp price movements, triggering the unusual movement of prices in both upward and downward directions. The multiple of Average True Range, for example, 1.5 x Average True Range value, can be used to track the abnormal price movements.
The ATR indicator is a nice chart analysis tool for keeping an eye on volatility, which is a variable that is always important in charting or investing. It is a good option when trying to gauge the overall strength of a move or for discovering a trading range. That being said, it is an indicator that is best used as a complement to more price direction-driven indicators. Once a price move has begun, the Average True Range can add a level of confidence (or lack, thereof) in that move, which can be beneficial for a trader.