The average true range (ATR) is a measure of volatility introduced by Welles Wilder in his book, “New Concepts in Technical Trading Systems.” The true range indicator is the greatest of the following: current high less the current low, the absolute value of the current high less the previous close and the absolute value of the current low less the previous close. The average true range is a moving average, generally 14 days, of the true ranges.
BREAKING DOWN ‘Average True Range – ATR’
Wilder originally developed the ATR for commodities, but the indicator can also be used for stocks and indices. Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR. The ATR may be used by market technicians to enter and exit trades, and it is a useful tool to add to a trading system. It was created to allow traders to more accurately measure the daily volatility of an asset by using simple calculations. The indicator does not indicate the price direction, rather it is used primarily to measure volatility caused by gaps and limit up or down moves. The ATR is fairly simple to calculate and only needs historical price data.
ATR Calculation Example
Traders can use shorter periods to generate more trading signals, while longer periods have a higher probability to generate less trading signals. For example, assume a short-term trader only wishes to analyze the volatility of a stock over a period of five trading days. Therefore, the trader could calculate the five-day ATR. Assuming the historical price data is arranged in reverse chronological order, the trader finds the maximum of the absolute value of the current high minus the current low, absolute value of the current high minus the previous close and the absolute value of the current low minus the previous close. These calculations of the true range are done for the five most recent trading days and are then averaged to calculate the first value of the five-day ATR.
Estimated ATR Calculation
Assume the first value of the five-day ATR is calculated at 1.41 and the sixth day has a true range of 1.09. The sequential ATR value could be estimated by multiplying the previous value of the ATR by the number of days less one, and then adding the true range for the current period to the product. Next, divide the sum by the selected timeframe. For example, the second value of the ATR is estimated to be 1.35, or (1.41 * (5 – 1) + (1.09)) / 5. The formula could be repeated over the entire time period.
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