Average True Range
It is an average of real ranges over a specific time period and is a tool for determining market volatility.
What Is the Average True Range (ATR)?
Ever wondered what indicator you can use to gauge market volatility? Well, the Average True Range it is. This indicator was developed by a famous American mechanical engineer, J. Welles Wilder, in 1978.
Mr. Wilder, by profession, was a mechanical indicator who first described the ATR indicator in his book, “New Concepts in Technical Trading Systems.”
This post will explain how this indicator functions, why it is significant, and, most importantly, how we can utilize it to increase trading profitability.
The Average True Range, generally, is the sum of all valid ranges of a particular stock for a specific period. Calculating the volatility is by accounting for the gaps that are formed in the price of that stock.
As a default setting, it has a 14-day look-back period for the computation of the ATR values. The user can change this setting according to their discretion.
It also considers the daily, weekly, monthly, or intraday price periods for calculation.
The Average True Range is a volatility indicator that displays an asset's average daily movement over a specified period. The indicator can be used to place a stop-loss order and to help day traders determine when they might want to start a trade.
The indicator travels up and down when the price moves become larger or smaller. Traders use the indication to join and exit trades and establish a stop-loss to reduce the loss if the prices move in the opposite direction.
No single value can predict with absolute confidence whether a trend will reverse. Nevertheless, this indicator is very commonly used amongst the existing technical indicators.
The primary reason is to track the volatility of the stock. It displays the average daily movements of an item over a specific timeframe. It also helps the trader to a certain extent to place a stop-loss.
The ATR should not be used as the sole basis for entries and exits. Instead, it is a technique that can be used to help filter trades when combined with a general strategy.
How does the Average true range work?
The Average True Range is an average of real ranges over a specific period and is a tool for determining market volatility. Any gaps in price movement are considered when calculating volatility.
A widening average true range and wider bars are indicators of increasing market volatility. An increase in the indicator levels can signal the strength of a price reversal.
A widening average true range and wider bars are indicators of increasing market volatility. An increase in the indicator levels can signal the strength of a price reversal.
Because it is non-directional, an expanding average true range may indicate selling or buying pressure. However, high readings often follow a sharp rise or slump and aren't expected to persist for very long.
While a declining score denotes a decrease in market volatility, a rising value indicates substantial market volatility.
The true average range is not directional, which is another crucial distinction. Still, a price reversal accompanied by an increase in the indicator's values can suggest that the move has some momentum.
Uncontrolled movements result in the indicator rising sharply, and there is less chance that high levels will remain steady over time.
A low value denotes a series of periods with narrow ranges (quiet days). The lower volatility was brought on by the protracted sideways price movement that resulted in these low levels.
Uncontrolled movements result in the indicator rising sharply, and there is less chance that high levels will remain steady over time.
A low value denotes a series of periods with narrow ranges (quiet days). The lower volatility was brought on by the protracted sideways price movement that resulted in these low levels.
When the Average True Range readings are low, it indicates that the markets could consolidate and hints at the possibility that the previous move will continue. In addition, it helps identify any significant changes in a stock's volatility, which assists in entry and exit.
If a user wishes to measure unusual price changes in stock, they must multiply the ATR values by 1.5, giving them a rough range of where the market might move.
The Average True Range Formula and its Application
Finding the series of actual range values for that particular stock is the first stage in the computation of the formula.
If you want to find a stock’s entire range, you require a few inputs for the same:
The number of periods of bars (denoted as n) and the actual range (denoted as TR).
The true range can be calculated as follows:
TR = max[(high - low), abs(high - previous close), abs(low - previous close)]
According to the TR calculation formula above, assets' Open, High, Low, and Close values are considered for calculating ATR.
The default number of n is often 14, as ATR discloses the average volatility over the previous 14 days, and it is thought that a 14-day period provides the most reliable results.
With these values, you can easily calculate the ATR as follows:
ATR = (Previous ATR * (n - 1) + TR) / n
The current True Range is the highest of the following:
- Current high minus the current low,
- The total difference between today's high and the previous day’s closing price,
- The total difference between the previous day's closing price and today's low.
After all, Wilder was only interested in calculating the distance between two points—not their direction.
If the high is higher than the high of the previous period and the low is lower than the previous period's low, the current period's high-low range will be used as the True Range.
The True Range, which relies on absolute price changes, is the foundation of the indicator. Thus, the true average range depicts volatility as an absolute quantity. In other words, it is not displayed as a percentage of the most recent close.
As a result, equities with lower prices will have lower ATR values than those with higher prices. For instance, a $50 to $70 security will have significantly lower ATR values than a $300 to $400 security.
The indicator values are not comparable as a result. Long-term accurate range comparisons can be impossible even for significant price changes for a single asset, like a decrease from 80 to 30.
Day traders might plan profit targets and decide whether to attempt a trade using the information on how much an asset generally moves over a specific period.
The true range settings can be modified to suit our trading preferences. For instance, we can choose shorter intervals than the typical 14-day term if we want to engage in intraday trading.
In contrast to longer intervals, which have a higher likelihood of success but less frequent occurrence, shorter durations for intraday trading produce more signals with low probability.
Let us assume that a stock moves $2 on average each day. Despite the lack of significant news, the stock has already increased by $2.50 today. The trading range is $2.45 (high minus low).
Now that the price has moved by 22.5% more than the average, a strategy is giving you a buy signal.
The purchase signal might be correct, but considering how far off the average price has already moved, it might not be prudent to bet that it will increase further and extend the range. The deal defies the probabilities.
It shouldn't be the only factor considered when making entries and exits. However, when combined with a broad strategy, the valid range is a method that can be utilized to help filter trades.
The price has grown significantly and moved more than average, making it more likely to decrease and stay within the established price range.
Selling or shorting is probably a wise move, providing that a valid sell signal appears whenever the price is close to the top of the daily range and the content is significantly more than typical. Buying at that point is not advised.
Uses Of average true range
Assume that a swing trader who intends to hold a position for a few days wants to determine the true range for the previous nine days. To do this, the trader must examine several elements while deciding the past 9-day accurate content.
The trader must perform a few calculations before calculating the past 9-day average true range. First, the trader must determine the maximum absolute value of the current high minus the recent low.
Next, the trader must determine the absolute value of the current high minus the previous close. Moreover, the difference between the last close and the present low's total value.
The valid range will rise higher shortly after the market starts if you use it on an intraday chart, such as a one- or five-minute chart. For example, the average stock range increases during the first minute when the major U.S. exchanges open at 9:30 a.m. ET.
This indicator shows that volatility is higher than yesterday's close, and the opening is the most volatile moment of the day.
A company with a higher level of volatility will have a higher average true range, and vice versa for a stock with a lower level of volatility.
Traders use the indicator to join and exit trades and to set a stop-loss to limit losses if prices go in the other direction.
This indicator's daily oscillations reveal only how much the price is moving on average each minute.
Day traders can estimate how much the price might change in five or ten minutes using the indicator on a one-minute timeframe, in the same manner they do with the daily timeframe to determine how much an asset changes in a day.
This strategy may aid the use of stop-loss orders or profit targets.
The price is moving at around three cents per minute if the true average range on the one-minute chart is 0.07. Therefore, if you predict that the price will increase and decide to buy, you should anticipate that it will probably take at least five minutes to increase by 35 cents.
Limitations of Average True Range
Firstly, it is a flexible concept. No one number can predict with absolute confidence whether a trend will reverse or not.
When the stock consolidates, the average range alerts you to either side's likelihood of a breakthrough. Still, it does not explicitly forecast which way the breakout will occur.
Although they are relatively infrequent, trading signals produced by the ATR typically pinpoint meaningful breakout opportunities, allowing traders to profit from significant market movements.
It does not account for changes in an asset's price direction; it merely measures volatility. For instance, a quick rise in the values may lead some traders to believe that the existing trend is being confirmed, but this may not be true.
The second drawback is that no set rule says a given value of ATR will indicate whether a trend will persist or change direction. As a result, each trader may view the exact ATR figure differently.
Therefore, it is impossible to predict whether a specific trend will continue or reverse only by looking at the ATR.
The ATR is concerned with the volatility of the stock, and it does portray the direction of the store. However, ATR does not correlate with the order of the stock and generally shows market volatility.
ATR is a unique volatility indicator that depicts the level of interest or disinterest in a move, in contrast to MACD or RSI, which are directional indicators.
Strong motions typically have wide ranges or large True Ranges, whether moving in the same or opposite direction. This is especially true when a transfer first begins.
It's possible to combine monotonous motions with narrow ranges. Therefore, ATR can be used to validate the enthusiasm for a move or breakout. A positive reversal with an increase in ATR would be supported by intense buying pressure that is readily apparent.
Clear signs of intense selling pressure would support a bearish support breach with an increase in ATR.
These are a few of the ATR index's drawbacks. Nevertheless, ATR has a high success rate while producing fewer indications, making it a beneficial tool for swing trading.
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