Average True Range (ATR) Indicator

Volatility indicators

Average True Range indicator

Average True Range (ATR) indicator is one of the most influential technical analysis tools that track volatility in a predefined period of time. Unlike most of the indicators, ATR does not identify trends and only focuses on measuring volatility in a particular market. However recent developments suggest that most of the traders have added ATR indicators to charts to identify volatility as well as the potential trend tops and bottoms. 

The Average True Range indicator possesses a unique quality that it can compare the range for each successive day to measure the commitment. The expansion and contraction of the ranges indicate the commitment and eagerness in the market. The ATR indicator was originally used in the commodities market. But now, traders apply it to all types of securities. 

  • Average true range (ATR) indicator is a technical tool to measure market volatility.
  • The standard configuration derives from the 14-day moving average of a series of true range indicators.
  • It decomposes the entire range of an asset price for that period.

What is the ATR indicator?

The Average True Range’s up and down movement according to the price of the asset gives a measure of volatility. The higher ATR value shows greater volatility and lower ATR value means less volatility. The Average True Range indicator tells to place a stop or limit order and time to open or close the trade. It tracks volatility in the market and timely indicates when price movements show more or less periodic behavior.

 J. Welles Wilder Jr. described the Average True Range for the very first time in 1978. He was a famous and truly expert technical analyst. He is also the inventor of several other technical analysis tools besides the Average True Range. This famous trading genius also invented the Relative Strength Index (RSI), the Parabolic SAR, and the Average Directional Index (ADI).

The calculations and formula of the Average True Range

The Average True Range indicator is smoother that represents smoothed moving averages of a given period. Welles Wilder originally suggested smoothing the moving averages of 14 periods. However, traders softwares can calculate it on several bases such as intraday, daily, weekly, etc. 

To calculate the Average True Range, the true range needs to be calculated first. The true range can be calculated by taking the highest value from the following three calculations.

  1. The current high – the current low
  2. Current low – the previous close
  3. The current high – the previous close

This step repeats throughout a particular timeframe to reach to a moving average of a true range series. The formula of the Average True Range indicator is:

The Average True Range indicator (ATR) = [{Previous ATR × (n -1)} + TRUE RANGE] / n

What does the Average True Range indicator tell traders?

The Average True Range indicator serves many purposes by indicating the following signals.

  • The Average True Range indicator measures the volatility in the current market. The high volatility gives a high value of ATR while a low value of volatility gives a low value of ATR. These ATR values are crucial hints to enter or exit trades. 
  • The Average True Range indicator also tells about the size of trade in derivatives markets. The sizing decisions heavily based on the volatility measures provided by the ATR. 
  • The increased volatility in the market suggests an expanding ATR that indicates selling or buying pressure. The low ATR values show a series of small range periods and represent low volatility in the market. The prolonged session of low ATR values shows continuation move, possible reversal, or market consolidation. 
  • The Average True Range indicator provides excellent signals to enter or exit the market, put a stop loss, and take profit orders. 

How to use the Average True Range indicator?

The use of the Average True Range indicator is quite easy and it is very helpful because of its volatility measures. The technical analysts and experts suggest that its magnitude is at an inverse proportion to the position size of a trading asset. This relationship ensures that the size of each position is almost equal in terms of risk. 

Traders prefer to implement a trailing stop at a particular level before the current market price in a volatile market. This implementation helps in two ways. First, it helps to lock in profits. Secondly, it helps to protect against unfavorable movements when the prices are unpredictable. The Average True Range indicator assists in this regard by indicating rising or falling volatility in the market. Traders would want to increase or decrease the level of trailing stop to secure their profits or protecting themselves against losses.

Traders prepare for high volatility and high level of price fluctuations when the ATR values are high. So what they do in this situation? They would simply adjust their stop-loss orders at a distance to avoid premature trade exit. On the other hand, traders would adjust stop-loss closer when the ATR values will be lower. However, there are no hard and fast rules to set stop-loss in accordance with the ATR. It heavily depends upon the risk tolerance level of each trader. 

The Average True Range indicator is also a wonderful tool to understand the trade’s profit potentials. Traders tend to adjust far take profits when the volatility is high and closer take profit when the volatility is low.

Limitations of the Average True Range indicator

The Average True Range indicator is very useful in the trading markets. It is one of the most popular indicators among both, technical analysts and trading experts. However, there are certain limitations of the ATR indicator as well that must be accounted for. It must be remembered that the ATR measures only volatility and it is not a trend-following indicator. Moreover, the ATR values are just subjective measures that are open to hundreds of different possible interpretations. There is no single ATR value that can confirm an upcoming trend reversal. Therefore, traders mustn’t use the ATR indicator in isolation. 

Conclusion 

The Average True Range indicator gives a smoothed moving average of a given period. It was originally developed to use in the commodities market only. But now, it has found its uses in the stock, forex, and index as well. Welles Wider suggests using a 14-day moving average for the average true range calculations. However, shorter or longer timeframes can also be used to measure the ATR. Although the ATR indicator is an exceptional tool to measure volatility, it should not be used in isolation for trading decisions. It can be used in conjunction with other certain indicators for confirmation of open/close positions. Bolinger bands and Keltner channels can be used to support the ATR indicator. 

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