The Average True Range (ATR) is a popular technical analysis tool designed to measure market volatility. Originally developed by J. Welles Wilder for commodities, it has since become a standard indicator used across various trading instruments, including stocks, forex, and futures. Unlike many volatility metrics, the ATR focuses on the degree of price movement rather than the direction, making it invaluable for traders looking to gauge market enthusiasm and set informed stop-loss or take-profit levels.
What Is the Average True Range (ATR)?
The ATR is a moving average of the True Range values over a specified period. True Range expands upon the simple daily range (high minus low) by incorporating gaps and limit moves that occur between trading sessions. This makes it a more comprehensive measure of volatility.
The indicator helps traders understand how much an asset typically moves within a given period. A higher ATR suggests greater volatility, while a lower ATR indicates calmer, more consolidated markets.
How the Average True Range Is Calculated
To compute the ATR, you need three data points for each period: the high, low, and closing prices.
Step 1: Calculate the True Range
The True Range is the greatest of the following:
- Current high minus current low
- Absolute value of current high minus previous close
- Absolute value of current low minus previous close
This captures intraday volatility as well as any gap movements from the previous close.
Step 2: Smooth the True Range Values
Wilder recommended using a 14-period smoothed moving average. While the original calculation used a specific smoothing technique, many modern platforms use an exponential moving average (EMA) for efficiency.
The formula for the ATR is:
[ \text{ATR} = \frac{\text{Previous ATR} \times 13 + \text{Current True Range}}{14} ]
For the first calculation, a simple average of the True Range over the initial 14 periods is used.
Interpreting the Average True Range
The ATR provides insight into market sentiment and volatility conditions:
- Rising ATR: Indicates increasing volatility, often accompanying significant price moves, breakouts, or emotional trading phases.
- Falling ATR: Suggests decreasing volatility and possible consolidation, often occurring during indecision or low-interest periods.
One key advantage of the ATR is that it is a first-moment measure of volatility. Unlike standard deviation, which squares deviations and can be influenced by outliers, the ATR offers a more robust and intuitive reading of price variability.
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Normalized Average True Range
For easier comparison between different assets or timeframes, traders often use the Normalized Average True Range, expressed as a percentage:
[ \text{Normalized ATR} = \frac{\text{ATR}}{\text{Close}} \times 100 ]
This allows for volatility comparisons across various securities or historical periods.
Using ATR in Trading Strategies
Traders use the ATR in several practical ways:
1. Setting Stop-Loss Orders
A common technique is to place stop-loss orders at a multiple of the ATR away from the entry price. For example, a 2x ATR stop-loss helps avoid being stopped out by normal market noise.
2. Identifying Breakouts
A sudden increase in ATR often precedes or accompanies significant price movements. Traders watch for expanding ATR to confirm breakout validity.
3. Position Sizing
Volatility-based position sizing involves adjusting trade volume based on the ATR. Higher volatility may warrant smaller positions to manage risk.
Frequently Asked Questions
What is the best period setting for ATR?
The standard setting is 14 periods, which works well across various timeframes. Shorter periods make the ATR more sensitive, while longer periods provide a smoother, slower-reacting indicator.
Can ATR predict price direction?
No. The ATR measures volatility, not trend direction. It tells you how much the price is moving, but not whether it’s going up or down. Always use it alongside trend or momentum indicators.
Is ATR useful for all markets?
Yes. The ATR is effective in trending and ranging markets alike. It helps in volatility assessment whether you’re trading stocks, forex, commodities, or cryptocurrencies.
How does ATR compare to Bollinger Bands?
While both measure volatility, Bollinger Bands use standard deviation and form a dynamic channel around price. The ATR is a single line that reflects absolute volatility, making it simpler for stop-loss and risk management.
Can I use ATR for long-term investing?
Absolutely. Long-term investors use the ATR to assess market conditions and adjust entry or exit points based on historical volatility patterns.
Why is ATR called a “first-moment” estimator?
It directly averages price ranges without squaring values (as standard deviation does), making it less sensitive to extreme outliers and easier to interpret.
Summary
The Average True Range is a versatile and robust tool for measuring market volatility. Developed by J. Welles Wilder, it helps traders manage risk, set stops, and gauge market sentiment without predicting direction. Whether you’re a day trader or a long-term investor, incorporating ATR into your analysis can lead to more disciplined and informed trading decisions.