Average True Range (ATR)

The Average True Range (ATR) is a technical indicator that gauges the volatility of an asset's price. As a volatility indicator, ATR reflects the average price fluctuations over a specified time period. It was introduced by Welles Wilder in his book, “New Concepts in Technical Trading Systems,” which also features the Parabolic SAR, RSI, and the Directional Movement Concept (ADX).

The Average True Range can attain high values when price movements are significant and rapid. Conversely, low ATR values are common during extended periods of sideways movement, typically occurring at market peaks and during consolidation phases.

The Average True Range (ATR) can be interpreted as follows: a higher ATR value indicates a greater likelihood of a trend change, while a lower value suggests a weaker trend movement. It is important to note that the ATR does not indicate the direction of price trends; it solely measures the degree of price volatility.

To calculate the ATR, one must first determine the True Range. The True Range considers the current period's high/low range and the previous period's close (if necessary). Three calculations must be performed and compared:

The True Range (TR) is defined as the maximum of the following:

• The Current Period High minus the Current Period Low
• The Absolute Value of the Current Period High minus the Previous Period Close
• The Absolute Value of the Current Period Low minus the Previous Period Close

True Range = max[(high – low), abs(high – previous close), abs(low – previous close)]

The absolute value is utilized because the ATR measures volatility, not price direction, thus avoiding negative numbers. Once the True Range is established, the Average True Range can be plotted. You can think of the ATR as a moving average of the True Range.

Period: (14): This refers to the number of periods used in the range calculation. For hourly data, the period represents hours; for daily charts, it indicates days; for weekly charts, it signifies weeks, and so forth. Wilder originally used a period of 7, while other common periods include 14 and 20.

Welles Wilder created the Average True Range (ATR) as a tool for measuring volatility. Using daily charts, Wilder defined the True Range as the greatest of the following distances:

• The distance from today’s high to today’s low.
• The distance from yesterday’s close to today’s high.
• The distance from yesterday’s close to today’s low.

The True Range measures market volatility and is a crucial component of indicators like ADX (Average Directional Movement) and ADXR (Average Directional Movement Rating), which help identify market direction.

The Average True Range indicator highlights periods of high and low market volatility. High volatility indicates ongoing price fluctuations, while low volatility signifies minimal price activity. Assessing market volatility can aid in identifying buy and sell signals, as well as potential risks.

Markets characterized by high price fluctuations present greater risk/reward potential, as prices can rise and fall rapidly, providing traders with more opportunities to buy or sell. When market volatility increases, the ATR typically peaks and rises in value. In contrast, during periods of low volatility, the ATR decreases.

Generally, a market tends to maintain the direction of its initial price movement, although this is not a strict rule. Traders often use the Average True Range to assess market volatility and then rely on other technical indicators to determine market direction.