Typically, indicators deal with predicting the price direction. However, Average True Range indicator (ATR) is different as it is a volatility indicator. ATR basically shows the level of interest or level of disinterest in a particular price movement of a stock.
Why Was ATR developed?
Welles Wilder developed Average True Range indicator for stocks and commodities that are quite volatile. Such stocks frequently open with gap moves as well as limit moves. As the then-existing formulas for volatility did not account for these gap and limit moves, Wilder developed ATR for capturing this omitted volatility.
Understanding the Calculation Behind Average True Range
The calculation of ATR just requires historical data of price.
Step 1: The first step in the calculation of Average True Range indicator is to find out the True Range.
True Range (TR) is basically the biggest of any of the below three values and is used for determining the level of volatility.
Value #1: Current High – Current Low
Value #2: absolute value |Current High – Previous Close|
Value #3: absolute value |Current Low – Previous Close|
Hence, TR = max (value1, value2, value3)
This is depicted in the below figure for ease of understanding. The values of ‘Today’s candle’ signifies current values, while the values of ‘Yesterday’s candle’ signifies previous values.
Step 2: Calculate the Average True Range. This is actually the ‘N’ day exponential moving average of True Ranges (TR). Usually, the value of ‘N’ is 14 days.
ATR = ‘N’ day EMA of TR
Hence, value of today’s (current) ATR = {(13 * Previous ATR) + Current TR}/ 14
Use of Average True Range Indicator
Average True Range Indicator is used for early identification of trend changes and for validating whether the move or breakout is valid.
- Whenever there are strong moves of the stock (in either direction), it would be accompanied by a large value of Average True Range, especially at the beginning of the move.
- On the other hand, false or uninspiring moves are usually accompanied by relatively narrow ranges.
For example, when there is a bullish reversal and the value of ATR increases, it shows that there is a strong buying pressure, thus reinforcing the reversal. On the other hand, when there is a bearish reversal with an increase in ATR, it shows strong selling pressure, reinforcing the support break.
Basically, a high value of Average True Range Indicator warns that a market top or market bottom being formed.
The figure below shows that a high value of ATR leads to a price rally. To confirm this, moving average cross was also taken into account.
How Traders Use ATR?
ATR is used as an entry as well as exit signal for trades.
- Traders enter new trades whenever the Average True Range Indicator shows a high value.
- When the value of Average True Range Indicator remains in a narrow range for a stock, traders can exit the trade and pick other lucrative trades in lieu of that stock.
Note that traders typically use Average True Range Indicator in conjunction with other indicators.
Happy Trading!
Tara