Average True Range (ATR)
When it comes to trading, one of the most important aspects is to have a reliable tool to determine the volatility of a security. One such tool is the Average True Range (ATR) indicator. The ATR is a powerful indicator that can help traders better understand the price action of a security, which can help them make better-informed trading decisions.
What is the Average True Range (ATR)?
The ATR was developed by J. Welles Wilder in his 1978 book, “New Concepts in Technical Trading Systems”. The ATR is a simple and powerful technical indicator that measures the volatility of a security. The ATR is calculated by taking the average of the True Range (TR) over a certain period.
The True Range is the greatest of the following:
- Current high minus the current low
- Absolute value of the current high minus the previous close
- Absolute value of the current low minus the previous close
The ATR is used to determine the volatility of a security over a specific time period. A higher ATR indicates that the security is more volatile, while a lower ATR indicates that the security is less volatile.
How to calculate the Average True Range (ATR)
The ATR is calculated using the following formula:
TR = Max[(High – Low), Abs(High – Close previous), Abs(Low – Close previous)]
ATR = [(n – 1) ATR previous + TR] / n
Where:
- TR = True Range
- High = Current high of the security
- Low = Current low of the security
- Close previous = Previous closing price of the security
- n = Number of periods used to calculate the ATR
- ATR previous = Previous ATR value
How to use the Average True Range (ATR)
The ATR is a versatile indicator that can be used in a number of different ways. Here are three common strategies:
1. Trend following:
One way of using the ATR is to follow trends. When the ATR is rising, it means that the security is becoming more volatile, which could indicate the onset of a new trend. When the ATR is falling, it means that the security is becoming less volatile, which could indicate the end of a trend.
2. Stop loss placement:
Another way of using the ATR is to place stop losses. The ATR can be used to calculate a trailing stop loss based on the volatility of the security. For example, if the ATR is 1%, then a trader could set a stop loss 1% away from the current price. This can help protect the trader from large losses in volatile markets.
3. Range trading:
Finally, the ATR can be used for range trading. Range traders buy and sell securities based on the expectation that they will remain within a certain price range. The ATR can be used to determine the upper and lower limits of the range. For example, if the ATR is 1%, then a range trader could buy when the price is at the lower end of the range and sell when the price is at the upper end of the range.
Conclusion
The Average True Range (ATR) is a powerful indicator that can help traders better understand the price action of a security. The ATR is easy to calculate and can be used in a number of different ways, including trend following, stop loss placement, and range trading. Traders who use the ATR can increase their chances of making better-informed trading decisions and can reduce their risk in volatile markets.