Understanding the Average True Range: A Comprehensive Guide
Introduction
The Average True Range (ATR) is a technical indicator used primarily to measure volatility in financial markets. Developed by J. Welles Wilder in 1978, the ATR calculates the true range for each period and averages the values over time, providing a representation of the current market volatility.
Calculation of the ATR
To calculate the ATR, three steps must be followed:
- Determine the True Range (TR) for each period using the following formula:
TR = max[(High - Low), abs(High - Close_previous), abs(Low - Close_previous)]where High is the highest price during the period, Low is the lowest price during the period, and Close_previous is the closing price of the previous period. - Calculate the average TR for a chosen number of periods (typically 14) using the simple moving average method:
ATR_initial = (TR1 + TR2 + ... + TRn) / n - Update the ATR for subsequent periods using the following formula:
ATR_new = [(ATR_previous * (n-1)) + TR_current] / n
Example scanners based on ATR
Interpretation of the ATR
The ATR does not provide directional signals like other technical indicators; instead, it helps traders understand the market’s volatility level. A higher ATR value indicates higher volatility, while a lower ATR value implies lower volatility.
Traders can use the ATR to assess the strength of price moves, as significant price movements accompanied by high ATR values suggest a strong trend. Conversely, price moves with low ATR values may indicate a weak or consolidating market.
How to Use the ATR in Trading
- Understanding the signals generated by the ATR: When the ATR value increases, it indicates a rise in volatility, which may suggest a potential trend or reversal. A decrease in the ATR value may signify decreasing volatility and the possibility of a consolidating or range-bound market.
- Combining the ATR with other indicators: To improve the accuracy of their market analysis, traders often combine the ATR with other technical indicators such as moving averages, the Relative Strength Index (RSI), or the Moving Average Convergence Divergence (MACD).
- Using the ATR for entry and exit signals: Traders can use the ATR to establish stop-loss and profit target levels. By multiplying the ATR value by a specific factor (usually between 1 and 3), traders can set their stop-loss orders at a safe distance from the current market price to accommodate volatility.
Advantages of the ATR
- Measuring volatility: The ATR effectively measures market volatility, enabling traders to adapt their trading strategies accordingly.
- Risk management: By using the ATR to set stop-loss orders, traders can better manage their risk by considering the current market volatility.
- Flexibility: The ATR can be applied to various financial instruments and timeframes, making it a versatile tool for traders.
Limitations of the ATR
- Lack of directional information: Unlike other technical indicators, the ATR does not provide information about the market’s direction, so traders must use it in conjunction with other indicators to obtain a complete market analysis.
- Lagging nature: As a moving average-based indicator, the ATR lags behind the current market price, which may result in delayed signals.
- Inefficiency during non-trending markets: The ATR is more effective during trending markets, while its usefulness diminishes in range-bound or sideways markets.
Example strategy based on ATR
The Bottom Line
In summary, the Average True Range is a valuable technical indicator for measuring market volatility and managing risk. Although it doesn’t provide directional information, when used in conjunction with other technical indicators and fundamental analysis, the ATR can significantly enhance a trader’s understanding of market conditions and facilitate better decision-making. It is essential to be aware of its limitations and to utilize it as part of a comprehensive trading strategy.
