Average True Range (ATR) in Trading Explained for Dummies

 

What is the average true range (ATR)? 

  The average true range (ATR) is an indicator that is used in technical analysis to measure market volatility, indicating how much the price of a security (asset) moves during a given period of time.   

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Short history of ATR

  The ATR concept was created by J. Welles Wilder Jr. (1935 - 2021), from the USA, who introduced the technical indicator in his book New Concepts in Technical Trading Systems, which was published in 1978. The book also included other important technical indicators that were invented by Wilder. For example, the Relative Strength Index (RSI), Average Directional Index, and the Parabolic Stop and Reverse (SAR).    Notably, Wilder was a mechanical engineer, turned real estate developer, turned technical analyst.     ATR was originally created for the commodities market. It is currently used in the trading of stocks (shares), futures, and forex (foreign exchange).   

How to calculate ATR 

  Average true range (ATR) can be calculated by using varying periods. For example, it can be calculated on an intraday, daily, weekly, or monthly basis.    It is relatively simple to calculate the ATR, and it only needs historical price data.   

Calculation of the true range (TR) value  

  Average true range (ATR) is based on the true range (TR) principle, which uses absolute price changes. In the exact sense of the word, this implies that ATR reflects volatility at an absolute level. Put differently, the ATR is not indicated as a percentage of the current closing price.     The first step in calculating ATR is to obtain a series of true range (TR) values for a given financial instrument, such as a security. For example, the true range for a given trading day would be the highest number obtained from the following calculations: 

• Trading day’s high minus yesterday’s close 
• Trading day’s low minus yesterday’s close 
• Trading day’s high minus trading day’s low 

  Let us say we obtained the following information regarding the share price of company WWW: 

• Today’s trading high = R25.50 
• Today’s trading low = R23.00 
• Yesterday’s close = R24.00 

  Let us now determine today’s true range value of the shares of company WWW by using the highest of the following three calculations: 

• R25.50 - R24.00 = R1.50 
• R23.00 - R24.00 = (R1.00) 
• R25.50 - R23.00 = R2.50 

  R2.50 is the highest value. Thus, it will be used in the calculation of the ATR.  It does not matter whether the highest number is positive or negative.    

Determining the ATR 

  The number of periods used in the calculation of the ATR is usually 14 days. However, shorter periods can also be used, depending on the trader’s discretion.    

• Previous ATR is available 

Let us assume the previous ATR of company WWW is R3.00, which can be used to determine the company’s current 14-day period ATR. The formula for the calculation is:  Current ATR = Previous ATR (n – 1) + TR                                                n                         = R3.00 (14 – 1) + R2.50                                                14                         = R3.00 (13) + R2.50                                              14                          = R39.00 + R2.50                                           14                           = R41.50/14                            = R2.96  Thus, the shares of company WWW closed the trading day with an average volatility of R2.96.   

• Previous ATR is not available 

When the previous ATR is not available, the true range for each of the previous periods (for example, 14 days) has to be calculated to determine all the highest values for each day.   Subsequently, you have to add up all the highest values and multiply the result by 1/n, where n = number of periods/days. This will give you the result to calculate the current ATR.  Example  For a 14-day period, the daily values of Company WWW’s shares are as follows: 

Day	High	Low	Yesterday’s close
Day 1	R 24.90	R 23.17	R 24.46
Day 2	R 25.50	R 24.02	R 24.56
Day 3	R 24.40	R 23.10	R 23.70
Day 4	R 26.10	R 25.50	R 25.60
Day 5	R 26.20	R 24.90	R 25.30
Day 6	R 26.50	R 25.40	R 25.70
Day 7	R 26.80	R 25.70	R 26.00
Day 8	R 27.00	R 25.80	R 26.10
Day 9	R 27.20	R 26.30	R 26.60
Day 10	R 27.70	R 26.10	R 26.95
Day 11	R 28.00	R 26.90	R 27.30
Day 12	R 28.30	R 27.20	R 27.70
Day 13	R 28.60	R 27.70	R 27.95
Day 14	R 28.90	R 27.50	R 28.10

The prices above are now used to calculate the true range (TR) for each of the fourteen days.   Where,   H = High  L = Low  Cp = Yesterday’s close   

Day	H minus L	H minus Cp	L minus Cp
Day 1	R 1.73	R 0.44	R (1.29)
Day 2	R 1.48	R 0.94	R (0.54)
Day 3	R 1.30	R 0.70	R (0.60)
Day 4	R 0.60	R 0.50	R (0.10)
Day 5	R 1.30	R 0.90	R (0.40)
Day 6	R 1.10	R 0.80	R (0.30)
Day 7	R 1.10	R 0.80	R (0.30)
Day 8	R 1.20	R 0.90	R (0.30)
Day 9	R 0.90	R 0.60	R (0.30)
Day 10	R 1.60	R 0.75	R (0.85)
Day 11	R 1.10	R 0.70	R (0.40)
Day 12	R 1.20	R 0.60	R (0.50)
Day 13	R 0.90	R 0.65	R (0.25)
Day 14	R 1.40	R 0.80	R (0.60)

  It is clear that all the highest values for each day are indicated in the H minus L column.  The next step is to add up all these results from this column: R1.73 + R1.48 + R1.30 + R0.60 + R1.30 + R1.10 + R1.10 + R1.20 + R0.90 + R1.60 + R1.10 + R1.20 + R0.90 + R1.40 = R16.91  Finally, the sum of R16.91 is multiplied by 1/n, where n = 14 (days).  1/n (R16.91)  = 1/14 (R16.91)  = 0.0714 x R16.91  = R1.21, which is the ATR for the previous period that can be used in the formula to determine the ATR for the current period of a particular security.      

The basics of ATR 

  ATR is a technical tool that is used in technical analysis to measure the degree of volatility. It does not predict the direction of future price movements or market direction.    It indicates how much the price of a security (asset) moves, on average, during a given period of time.    ATR is not a standalone technical indicator and should be used in combination with other technical indicators to enhance a trading strategy.    An increasing ATR value signals an increase in volatility in a financial market. On a trading chart, it is evident when the range of price bars is getting wider.     As mentioned, ATR is not directional, and an increasing ATR value may signify buying or selling pressure. An extreme spike in the ATR value is normally unsustainable.    A low ATR value is a sign that a financial market is moving sideways for a certain period of time. Furthermore, an extended period of a low ATR is an indication of the consolidation of the price of a security.    A good ATR depends on the security or asset. The general rule is that if the security (asset) is performing close to its generally accepted ATR, it can be considered normal. If the security (asset) suddenly has an ATR higher than its normal ATR, it might be an indication that further investigation is needed. Similarly, if it has a significantly lower ATR than its normal ATR, a trader should investigate why it is happening.    

Uses of average true range in trading 

  Average true range (ATR) enables investors and traders to integrate risk management into their trading strategies.    The ATR is primarily used to measure the daily volatility of a security (asset) by applying simple calculations.     Generally, the ATR can be used as an exit method, regardless of how the entry decision was made. The ATR can also provide a trader with an indication of what size trade to use in the derivatives markets.    The following scenario explains how the ATR is used for a trailing stop-loss.    A trailing stop-loss is a trading strategy to exit a trade if the price of the security (asset) moves against the trader. It also allows the trader to move the exit point if the price is moving in the trader's favour. Numerous day traders use the ATR to determine where to place their trailing stop-loss.    In practical terms, observe the current ATR value during a trade. A general rule is to multiply the ATR by 2 to determine an acceptable stop-loss point. This means that if you are buying a security, you might put a stop-loss at a level twice the value of the ATR below the entry price. If you go short on a security, you will prefer to place a stop-loss at a level twice the ATR’s value above the entry price.    If you have a long position on a trade and the price moves in your favour, you can continue to move the stop-loss to twice the ATR value below the price. In this case, the stop-loss only moves upward, not downward. Once it is moved up, the stop-loss remains there until: 

• It can be moved up again, or 
• The trade is closed due to the fact that the price is decreasing to reach the trailing stop-loss level.  

  The same process applies to short trades, with the exception that the stop-loss only moves down.    For example:   Let us assume a trader takes a long position on a security at R50.00, and the ATR is R0.50. The trader would place a stop-loss at R49.00 (2 x 50 cents below R50.00). The price increases to R51.00, while the ATR stays at 50 cents. The trailing stop-loss is now moved up to R50.00. When the price jumps to R53.50, the stop-loss moves up to R52.50. This process would continue until the price declines to reach the stop-loss point.   

Limitations of ATR 

  Although a useful technical tool to use in technical analysis, ATR has its limitations. For instance:  One of the indicator’s main limitations is that it only measures volatility and not the direction of price movements of securities or financial markets.     This may lead to misleading signals, for instance: 

• Causing traders who apply ATR to identify potential trading opportunities to buy shares of a company that are experiencing high levels of volatility, without knowing whether the price of the shares will likely decrease or increase.  
• An unexpected rise in the ATR following a significant move contrary to the prevailing trend may lead traders to understand that ATR is confirming the old trend, which may not be the case. 
• If a security has a low ATR, it may signal that the security is relatively solid and not likely to have significant price fluctuations. Although this may not always be the case, as the security may still encounter sudden price movements that can surprise and negatively affect traders. 

  Secondly, the ATR indicator is a subjective measure, implying it is subject to interpretation. No single ATR value is incontrovertible proof that a trend is about to reverse or not. Hence, ATR values should always be compared against previous valuations to learn more about the strength or weakness of a trend.    Note: This article does not constitute investment, financial or trading advice. Its purpose is mainly informative. Please obtain the advice of a professional, reputable, and regulated broker before making trading and investment decisions.  

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