What Is the Average True Range (ATR)?
The Average True Range (ATR) is a technical analysis tool designed to measure market volatility. Unlike many other indicators, the ATR is not used to predict price direction. Instead, it focuses exclusively on quantifying volatility, particularly that caused by price gaps or limit moves.
The History Behind the ATR
J. Welles Wilder developed the ATR and introduced it in his 1978 book, New Concepts in Technical Trading Systems. This publication also featured other now-classic indicators, such as the Relative Strength Index (RSI), the Average Directional Index (ADX), and the Parabolic SAR. Like these tools, the ATR remains widely used and holds significant influence in the field of technical analysis.
How the Average True Range Is Calculated
To calculate the ATR, you must first determine the True Range (TR). The True Range captures the price range between the most recent high and low, and if necessary, incorporates the previous period's closing price. It is the greatest of the following three values:
- The current period's high minus the current period's low
- The absolute value of the current period's high minus the previous close
- The absolute value of the current period's low minus the previous close
The formula is expressed as: True Range = max[(high - low), |high - previous close|, |low - previous close|]
Absolute values are used because the ATR measures only volatility, not price direction, ensuring no negative numbers. Once the True Range is calculated, the ATR is derived as the exponential moving average of these True Range values.
Interpreting the ATR: The Basics
The ATR is represented as a continuously plotted line, usually displayed in a separate window below the main price chart. Interpreting it is straightforward: a higher ATR value indicates higher market volatility.
- The number of periods used in the calculation can be customized, though 14 days is the most common setting.
- The ATR can be applied to various time frames—such as daily, weekly, or intraday—but daily remains the most popular.
Key Applications of the ATR
Gauging the Strength of a Price Move
As emphasized, the ATR is not designed to forecast future price movements. Instead, it is highly effective for assessing the strength behind a price move. For instance, when a security experiences a significant upward or downward movement or reversal, volatility typically increases. This causes the ATR to rise, providing insight into the underlying momentum of the move. Greater volatility during a large price swing often reflects increased market interest or trading pressure.
Conversely, during prolonged consolidation or sideways movement, volatility tends to decrease, resulting in a lower ATR. This can help traders identify range-bound trading conditions.
The Importance of Absolute Values
The ATR's reliance on absolute price differences is a critical feature. This means securities with higher price levels naturally exhibit higher ATR values, while those with lower prices show lower ATR values. Consequently, traders cannot directly compare ATR readings across different securities. What constitutes a high ATR for one asset may be normal for another. Therefore, it's essential to evaluate the ATR in the context of each security's individual price history and characteristics.
Illustrative Example:
- Apple (AAPL), trading above $450, might have an ATR reading exceeding 12.
- Ford (F), trading around $17, could have an ATR below 1.
This disparity highlights why cross-security ATR comparisons are not meaningful.
ATR Settings and Customization
Length
This setting determines the number of periods used to calculate the ATR. The default is 14 periods, but traders may adjust this based on their strategy and time frame.
Style
Users can customize the visibility of the ATR line, including its color, line thickness, and visual style (with 'Line' as the default). You can also choose to display a price line showing the current ATR value.
Precision
This controls the number of decimal places shown in the ATR value before rounding. A higher precision setting results in more decimal places, offering a more precise reading.
Integrating the ATR into Your Trading Strategy
The ATR is a valuable tool for monitoring volatility, a crucial variable in chart analysis and investment decisions. It is particularly useful for assessing the strength of a price movement or identifying potential trading ranges. However, it is most effective when used alongside directional indicators. Once a trend is established, the ATR can help gauge the conviction behind the move, providing an additional layer of confidence—or caution—for traders.
For those looking to implement these techniques with advanced tools, you can explore more strategies and real-time charting platforms.
Frequently Asked Questions
What is the primary use of the ATR indicator?
The ATR is primarily used to measure market volatility. It helps traders understand how much an asset's price is fluctuating, which is useful for setting stop-loss orders, identifying breakouts, or assessing the strength of a trend.
Can the ATR predict price direction?
No, the ATR does not predict price direction. It is a non-directional indicator that focuses solely on volatility. Traders often combine it with other tools that do provide directional bias to form a complete trading strategy.
Why is the default period setting 14?
The 14-period setting is a standard originally proposed by J. Welles Wilder. It provides a balance between responsiveness to recent price changes and smoothing out random noise, making it suitable for most time frames.
How can I use the ATR for risk management?
Traders frequently use the ATR to set stop-loss orders. For example, a stop might be placed a certain multiple of the ATR value away from the entry price. This adapts the stop to current volatility, helping to avoid being stopped out by normal market fluctuations.
Is the ATR equally effective on all time frames?
The ATR can be applied to any time frame, but its interpretation may vary. On shorter time frames, it captures intraday volatility, while on longer frames, it reflects broader market volatility. The key is to adjust the period setting to match your trading horizon.
Why can't I compare ATR values between different stocks?
Because the ATR is based on absolute price differences, a high-priced stock will naturally have a larger ATR value than a low-priced one, even if their percentage volatility is identical. Always assess the ATR relative to the asset's own price history.