The average true range (ATR) is a technical indicator to give you an idea of how much the price of an asset can move. However, it wouldn’t indicate the direction of the move for you.
ATR is a useful metric to assess the price volatility of assets for a given timeframe. It can be used to plan the entry and exit points of a trade.
Let us discuss what is the average true range indicator and how to calculate it.
What is the Average True Range (ATR)?
The average true range (ATR) is the price volatility method to assess the volatility of an asset in a given time frame.
ATR also considers price gaps for the given period of the asset. It can be calculated for any given period. However, it is commonly calculated for 14-periods for a given asset.
These 14 periods for ATR calculations can be performed for a minute, hour, day, week, or even months. For instance, a minute chart will update the ATR of an asset after every minute.
ATR is a technical indicator that can be used to evaluate the price volatility of an asset. Although it does not indicate the direction of the price movement, it can show the true range of an asset in a given period.
ATR was developed by J. Weller Wilder Jr. As a new technical indicator to measure the market volatility.
How to Calculate Average True Range (ATR)?
The first step to calculating the ATR is to determine the range period which is usually a 14-period base.
The next step is to find a series of true ranges for the given asset for the specified period. The true range of an asset is the maximum of the following three:
- Current high minus the previous close
- Current low minus the previous close
- Current high minus the current low
The maximum number out of these can be a positive or negative integer. Then, the average of true ranges is calculated for the given 14 periods.
It gives us the initial average true range value of the given asset. The subsequent values of the ATR can be calculated in the same way as well.
You can use this formula to use the subsequent ATR values to save time.
Average True Range = (Prior Average True Range × 13 + Current True Range) / 14
Traders can use the same process to calculate the ATR of a given asset for a shorter period as well. It can be used to generate more trading signals.
For instance, you can use the formula above to calculate the ATR of an asset for five days. You’ll simply replace 14 by 5 and 13 by 4 in the formula written above.
Example of Using Average True Range
Suppose you want to calculate the ATR of a stock ABC for 14 days. You can use the same approach outlined above to calculate the first 14-day ranges of the stock.
Then, you take out the average of these 14 figures to get the average range of the stock. Suppose, it comes out to be 1.35. The range for the next day is 1.28.
You can use the formula of ATR:
Average True Range = (Prior Average True Range × 13 + Current True Range) / 14
Average True Range = (1.35 × 13 + 1.28) / 14 = 1.345
How to Interpret Average True Range?
The ATR graph moves up and down as the price volatility of an asset changes. An expanding average true range of an asset means higher volatility.
However, this expansion does not imply a directional movement. Therefore, it can be either due to a short sale or a long buy.
Expanding ATRs usually do not last for long. Contrarily, a low expansion of ATR means low volatility of the asset. A consistently low ATR expansion may indicate price consolidation of an asset or it may indicate a reversal of a trend as well.
Investors can use ATR to plan their entry and exit strategies. It can be used to monitor the daily price volatility of an asset and plan accordingly.
Sudden price changes may result in an expanding ATR. However, to avoid these unusual movement triggers, investors can use an ATR multiplier to get better signals.
Using Average True Range for Trading Decisions
The average trading range is a useful metric that investors can use in their trading strategies. It can be used to generate trading signals.
For example, if a stock ABC has average price volatility of $1.0 daily, you can assess its ATR and make a trading decision.
Suppose the stock on a given day is trading at $1.30. It is already above its average price volatility. Suppose its ATR is $1.25 for the last 14 days.
Depending on other factors, you can argue that the asset price has fairly moved beyond its typical high point on a daily basis. You would want to go short on this stock anticipating the trend will reverse later in the day.
However, many other factors may contribute to the price hike. Therefore, if you see a valid signal, you should only then go for a short-sell on the ABC stock given the current circumstances.
In short, ATR should be used in conjunction with other indicators and not as a sole indicator of an exit or entry strategy.
Day Trading and ATR
Day traders can use the average true range is a volatility indicator for their stop-loss and ordering.
Day traders typically use a minute or five-minute price chart. Thus, they can use the ATR indicator to predict the price movements of an asset.
Suppose the price of an asset is seeing a declining trend with an ATR of 0.01. It means the asset is losing 1 cent per minute on a minute chart. Thus, it will take at least 10 minutes to fall by 10 cents.
The day trader can then arrange a short-sell trade or set a stop-loss order after seeing the ATR of the asset.
However, day traders must consider that stock prices see a sudden upward trend when stock markets start the trading session. Usually, the trends will follow the reversal trend throughout the day after that sudden lift.
Trailing Stop-Loss Orders and ATR
Better use of the ATR for day traders for setting up trailing stop-loss orders. A trailing stop-loss order allows a day trader to set an exit strategy while moving the exit point if the price movement is favorable.
A common method to benefit from ATR and trailing stop-loss orders is to multiply the ATR by two and use it in the exit strategy.
For instance, once you set the stop-loss to twice the ATR below the price, you can benefit by setting up a long trade. This way, the long trade will only move upwards or the stop-loss will ensure the exit for you if the price falls.
Similarly, day traders can set the ATR at twice the price for downward movements and set up short trades.
Advantages of Using ATR
The average true range is a useful technical indicator for traders.
It can be used to assess the price volatility of assets using the available historic data. It is fairly simple to calculate and can be interpreted easily.
Investors and day traders can use ATR as a price volatility assessment tool and plan their entry and exit strategies. However, it shouldn’t be used as the only indicator but should be used in conjunction with other metrics.
Overall, it is a good tool for price movement indication and assessing the price volatility for a given period for an asset.
Limitations of Using ATR
The average true range is a good tool to measure volatility but it does not assess the directional price movement of an asset.
It may result in mixed signals for day traders when there are sudden price changes in an asset. Also, it may send wrong signals to traders when price trends are at their turning points.
Another major drawback of ATR is that it is a subjective metric. It does not define volatility objectives and the results are open to interpretation by analysts.
It means two analysts may come to different conclusions when interpreting the same ATR data of an asset for the same given period.
