What is Average True Range?
Average true range (ATR) is an indicator that is used to measure the volatility facing a particular financial instrument. It was created by technical analyst Welles Wilder Jr., and it provides traders and investors a way of measuring the relative magnitudes of market pricing fluctuations.
First introduced in Wilder's 1978 book New Concepts in Technical Trading Systems, the idea of ATR quickly became widely popular. The indicator is often utilised as a component of various trading systems, and used alongside Wilder's assorted technical indicators. The relative strength index (RSI), directional movement, and the parabolic stop and reverse are the other well-known indicators included in the work.
Although initially developed for the trade of futures contracts, ATR can be applied to equities, debt instruments and currencies.
ATR: Quantifying True Range
The ATR is an indicator that focuses on the measure of volatility. Volatility is commonly defined as being the amount of price action present in the market of a specific financial product. As the price of a product fluctuates up and down, it's experiencing volatility. The larger the move in price, the greater the degree of volatility.
A key component of the ATR calculation is the concept of range, which is the distance price moves over a given period of time. In order to calculate range, take the high value of the period from the low value of the same period:
- Range = Period High - Period Low
For example, if using the daily time frame to view a security, the range is the difference between the highest traded price of the day and the lowest traded price of the day.
Instead of using a simple measure of range in its calculation, the ATR uses true range (TR). True range is defined as being the largest value observed through adhering to the following constraints:
- Measurement from the current period high to current period low
- Measurement from last period's close to current period's high
- Measurement from last period's close to current period's low
It is important to remember that ATR is not concerned with price direction, only the identification of volatility. Thus, in the event that the TR calculation produces a negative number, the absolute value of the measurement is used as the TR value.
True range takes into account the ability for price to quickly "gap" up or down. This is worth recognising, because price has a tendency to move rapidly and erratically depending upon market conditions.
A key aspect of the ATR is the "look-back period," which is the number of past periods that are to be used in the average calculation. Wilder suggests that 14 periods is optimal, but the proper periodicity may vary depending upon the timeframe and product being traded. The ATR calculation implements the mechanics of an exponential moving average as a way to minimise the impact of variance in range values.
Determining an ATR value has multiple steps, and it can be a daunting task to execute manually. However, current information systems technology has afforded traders the ability to observe the end result with little effort.
The following procedure is used for calculating an ATR assuming a data look-back period of 7:
- Identify the TR for each period 1 through 7
- Calculate the initial ATR value (ATRI): ATRI = ((Sum of TR's for all 7 periods) / 7)
- Calculate the current ATR (ATRC): ATRC = ((6 * ATRI ) + Current Period TR)) / 7
The calculated ATR is used as the current measurement of volatility facing the 8th period. It is a reflection of market volatility when taking into account the pricing fluctuations that occurred over the last seven periods. As time moves forward, the ATR is adjusted to remain current.
Although the on-the-fly calculation of ATR may seem like a daunting task, software trading platforms have made the process relatively easy. It is commonplace for ATR to be automatically updated and plotted on a pricing chart for visual consumption. Trading platforms such as Trading Station and MetaTrader 4 provide the ATR indicator for use at the trader's discretion.
Average True Range: Applications
Average True Range can function as both a trend-following and counter-trend indicator. If faced with a trending market, traders often conclude that a high ATR value is confirmation of potential price extension and trend continuation. Conversely, low ATR values can be interpreted as a lack of market participation and possible precursor to market consolidation, reversal or breakout.
The ATR indicator provides a concrete measure of the current market volatility facing a financial product. When used in conjunction with other aspects of fundamental and technical analysis, it can be a useful addition to nearly any trading approach.
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