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What is Average True Range?
What is Average True Range?
Average True Range, or ATR, is a volatility indicator developed by J. Welles Wilder for the commodities market. He believed that the extreme volatility in commodities prices rendered most indicators ineffective in capturing the full volatility experienced as a result of gap moves. Although the ATR is based on price movements, it does not reflect the direction of those movements. ATR is expressed as a dollar value, so an ATR of 0.13 means the average price movement between bars is $0.13. If you’re trading forex, the indicator is expressed in pips. Obviously, a high ATR indicates higher volatility, and a low ATR lower volatility, but this also must be taken in the context of the actual price of the asset. In other words, an ATR of 1.00 is high on a $10 stock, but low on a stock trading at $100. Average True Range is typically calculated on a 14-period interval, whether you use it on an intraday, daily, or more long-term basis. A new value is calculated at each interval, so if you’re using a daily chart, the ATR will change each day. Day traders using a 1-minute chart get a new ATR value each minute.
Here’s how ATR is calculated:
To begin, you start with the True Range, or TR, which is the greatest of either a) current high - current low, b) current low - previous close, or c) current high - previous close. You then calculate the TR over 14 periods and find the average. From there, the values are smoothed by taking into account the most recent period’s ATR. So, ATR = [(prior ATR x 13] + current period’s TR) / 14, which means that an actual ATR isn’t calculated until the 15th period. It’s important to note that ATR is, as the name indicates, an absolute value, not a percentage, so ATR values are all relative based on the price of the underlying asset. You cannot compare ATR across different assets, it can only be calculated and evaluated in relation to the asset you’re watching. Look at the two stocks below. The first, Coca Cola, is a low volatility stock, and you’ll notice that it traded between $45 and $50 for most of the period, and ATR stayed under 1.00 for the entire period except for a brief blip to 1.1 during a period of “high” volatility in December, when the U.S. market as a whole underwent a correction.
Compare that to a more volatile stock, AbbVie, which traded between roughly $80 and $90 for the bulk of the period with ATR in the 2.5 to 3.5 range.
So, how should traders and investors use ATR to shape their trading strategies? It can definitely be helpful in confirming buy and sell signals. If you were trading ABBV, you might get a buy signal from a strategy on November 30th as the price surges from $88, ultimately closing near $93. It may be a valid signal, but compared to the ATR, which was in the 2.5 range for that day, once the price moved beyond roughly $90.50 ($88 + ATR), going long might not be the right course of action, because ATR tells you that the price is most likely to fall back within the range. The price has already gone against the odds by moving so far outside it. In this case, it may be more prudent to short, especially in the context of a valid signal. In other words, ATR shouldn’t be your sole method of timing your entry and exit, but it can confirm your trade strategy and help you filter other signals. ATR is also valuable in setting a trailing stop. If you take a long position, a trailing stop based on ATR limits your risk by locking in your profits on a trade moving in your favor and getting you out of one that is moving against you. Here’s how it works, looking now at the KO chart: Imagine you take a long trade on KO on October 16 at $44.50. The ATR that day is 0.62, so you set your stop at 2x ATR below the entry point, or $43.26. As the price continues to climb, you move the stop-loss again to 2x ATR below. So on November 5th, for example, when the price at $48.50 and ATR at 0.8, you’d move the stop to $46.90. On November 19th, when the price hit $50 and ATR was 0.7, the stop would be set at $48.60, which is where you would exit the position when the price hit the stop-loss on the 21st. The stop-loss moves up with the price, but it never moves down. Once the stop is moved upward, it stays until you can either move it upward again, or you exit the trade. The process can also be applied to short positions, where the trailing stop is set at 2x ATR above the entry point.