What is the Average True Range (ATR)?

The Average True Range (ATR) is a technical analysis indicator used to measure market volatility. It was introduced by J. Welles Wilder Jr. in his book, New Concepts in Technical Trading Systems.

Unlike many other volatility indicators that focus on price direction, ATR solely measures the degree of price fluctuation. It is commonly used to:

• Identify potential breakout points.
• Determine stop-loss levels.
• Gauge the strength of a trend.

How is ATR Calculated?

The ATR is calculated using the true range (TR) over a specified period, usually 14 days. The true range is the greatest of the following:

1. Current high minus the current low.
2. Absolute value of the current high minus the previous close.
3. Absolute value of the current low minus the previous close.

Formula:

• TR = Max[(High - Low), Abs(High - Previous Close), Abs(Low - Previous Close)]

Once the true range is calculated, the ATR is determined using a moving average of the true range values. A common method is the exponential moving average (EMA).

Formula:

• ATR = EMA of TR (typically over 14 periods)

How to Use ATR in Trading?

• Volatility Assessment: A higher ATR value indicates higher volatility, while a lower ATR value indicates lower volatility.
• Stop-Loss Placement: ATR can be used to set stop-loss orders. A common strategy is to place the stop-loss a multiple of the ATR value away from the entry price.
• Trend Confirmation: Increasing ATR values can confirm the strength of a trend. A decreasing ATR may indicate a weakening trend.
• Breakout Identification: ATR can help identify potential breakout points. Look for a sustained increase in ATR following a period of low volatility.

Example

Let's say you are using a 14-day ATR. After 14 days of calculating the True Range, you'll calculate the ATR by averaging those values. If the ATR is consistently high (e.g., consistently above 50 pips), this signals high volatility. If the ATR is low (e.g., consistently below 20 pips), it signals low volatility.

Conclusion

The ATR is a valuable tool for traders looking to understand and adapt to market volatility. It can be used in various ways to improve trading strategies and manage risk effectively.