The Average true indicator or ATR is a volatility indicator showing how chosen assets move on average during a specific period. Day traders use this indicator to identify potential trades they can enter.
This tool also helps with determining settings of when to apply stop-loss. Keep reading the article to learn what is average true range, its formula, what it tells traders, and how to calculate ATR.
Understanding the ATR Indicator
So, what is the average true range? The average true range (ATR) indicator moves up and down along the price moves in an asset that is becoming larger or smaller. Every time a given period passes, the ATR has to be calculated again. If it’s a one-minute chart, it is calculated every minute. If it’s a daily chart, then calculations are made once a day.
All these calculations are made to form a continuous line to check the asset’s volatility over a specific period. The calculation of the ATR indicator requires determining a series of TRs (true ranges). The true range of a specific period is the greatest of the following:
- the current high minus the previous close;
- the current low minus the previous close;
- the current high minus the current low.
In this calculation, it doesn’t matter if a trader gets a negative number. Any highest absolute value is used in the ATR calculation. The trader has to record each value for each period. Then the average is taken.
The standard number of periods suggested by the indicator developer, J. Welles Wilder, Jr., is 14. Wilder also suggests this formula for all following periods:
((prior ATR x 13) + current TR) / 141 = current ATR
Note: the calculation requires determining the initial 14-period ATR and only then to use these figures in the formula. This formula is used to smooth out the data.
ATR and Trading Decisions
Day traders benefit from using this indicator since they can tell how much an asset moves over a specific period. This tool provides traders with important data on whether to buy stocks.
Suppose a stock moves $1 a day; it’s the average. No important economic or geopolitical events affect the market, yet the stock is already up to $1.20 on the day. The trading range calculated as high minus low shows $1.35.
It means that the price has moved 35% more than the average. The indicator shows buy signals. The signal could be real, but since the price has already increased significantly, it may be a bad idea.
Instead of increasing, the price may start decreasing. If a trader buys a stock, they may lose profit. The logic says that the price will most likely fall back to the previous price or remain at the established range.
But if you already own the stock since you bought it at a low price, you may now sell it. But verify that the stock will drop in price before making a rash decision.
But if you already had an investment in the stock when it was at a low price, you may now sell it. But verify that the stock will drop in price before making a rash decision.
Experienced traders don’t recommend making decisions only based on the ATR. Any indicator has to be used in combination with other tools that are a part of a trading strategy.
A simple example is described above when the price has moved 35%. It does seem logical to sell a stock, but only after verifying that the signal is valid. An individual could use another indicator to confirm a trend, and only then act accordingly.
When making a decision, consider reviewing historical ATR. Even though the stock may move up or down, check the historical ATR since it could be normal for the given stock.
What Does ATR Tell You?
Wilder recommends using the ATR for commodities, but it’s possible to apply it with other indicators for indices and stocks. It’s rather easy to interpret the indicator. A low volatility stock has a lower average true range. Similarly, a high volatility stock has a high ATR.
The ATR also may tell where the entry and exit points are. The tool can give rather accurate data about the volatility of a chosen asset. Moreover, the calculation is simple, so even beginners can easily master the skill.
However, the indicator won’t show the price direction, so it’s your task to choose another indicator to get more data. You need historical data to determine the volatility of an asset accurately.
The average true range is often used as an exit method. It doesn’t matter how the entry decision was made. One of the most popular exit techniques is the one developed by Chuck LeBeau, the “chandelier exit.”
The technique places a trailing stop under the highest high that the stock manages to reach since a trader entered trades. The highest high and the stop level show the distance that is defined as some multiple times the ATR.
For instance, traders can subtract three times the value of the average true range from the highest high since an individual entered trades. The indicator can also tell what size trade to put on in derivatives markets.
The average true range also helps with determining the stop-loss. It allows traders to figure out at which point they should exit trades to avoid losing profit.
The ATR Formula
As mentioned, to calculate ATR, you have to find a series of true range values for an asset. The asset’s high minus its low is its price for the specific trading day.
(1 / n)i=1(n)TRi = ATR
A more detailed true range formula is here:
Max [(H − L), Abs(H − CP), Abs(L − CP)] = TR
“TRi” is a particular true range, and “n” is the time period used by the trader. Could be any time period, although the developer recommends using 14 days.
How to Calculate ATR
As mentioned, the indicator developer recommends using 14 days, but there are other options. If you want to generate more signals, choose shorter periods. Shorter periods produce signals with a higher frequency. However, longer periods have a higher probability of generating signals.
Here’s an example. A trader has chosen an asset and now wants to determine its volatility over a period of six days. The individual has to calculate the ATR by choosing a six-day period.
The historical price data is probably arranged in reverse order, so the trader must find the absolute value’s maximum of the current high minus the current low, the current high’s maximum value minus the previous close, and the current low’s absolute value minus the previous close.
When calculating ATR, the trader should consider the six most recent trading days. Then the trader arranges these figures to calculate the first value of the six-day ATR.
Disadvantages of the Average True Range (ATR)
First things first, do not make your trading decisions based only on one indicator. The ATR may produce a signal which is open to interpretation. In simple words, it’s not an objective measure.
The average true range indicator can’t guarantee a 100% result when it comes to potential trends. It may seem like the trend is about to reverse, but you should verify it by using another indicator. You can make a decision only if both indicators show that the trend is reversing.
It’s also possible to verify the trend reversal by comparing current results to historical data. That way, traders get an understanding of how the asset usually moves on the market. In some cases, it may seem like the trend is about to reverse or begin, but the historical reading may prove that it’s the standard behavior of an asset.
Another disadvantage of the indicator is that it only measures volatility but can’t tell the direction of an asset’s price. To figure out in what direction the asset is moving, traders have to use other indicators.
The problem with measuring volatility is that calculations sometimes show mixed signals. It’s especially dangerous for traders when trends are at turning points. An unexpected increase in the average true range and a large move against the prevailing trend may look like a trend is about to reverse, but it could be a false signal.
To sum up, the ATR indicator has to be used in combination with other tools. For example, consider using moving averages to confirm the trend. Or apply momentum indicators to determine how strong the trend is.