Average True Range (ATR): The Volatility Indicator Every Trader Needs
Average True Range (ATR) is a technical indicator that measures market volatility by calculating the average range of price movement over a specific period. Created by J. Welles Wilder in 1978, ATR helps traders understand how much a stock typically moves, making it a useful tool for understanding market dynamics and price volatility.
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What Is Average True Range?
Average True Range (ATR) is a volatility indicator that shows how much an asset moves, on average, during a given time frame. Unlike other indicators that measure direction, ATR purely measures volatility—the degree of price movement regardless of direction.
Note: ATR is expressed in dollar terms for stocks (or the currency the stock trades in), not as a percentage. A stock with an ATR of $2.50 moves an average of $2.50 per day.
How ATR Works
ATR calculates the greatest of three values for each period:
- Current high minus current low
- Current high minus previous close (absolute value)
- Current low minus previous close (absolute value)
This "True Range" captures gaps and limit moves that simple range calculations would miss. ATR then averages these True Range values over a specified period, typically 14 days.
Calculating ATR Step-by-Step
ATR Formula
True Range (TR) = MAX of: • Current High - Current Low • |Current High - Previous Close| • |Current Low - Previous Close| ATR = Moving Average of True Range over N periods
Example Calculation:
Let's calculate TR for a stock with:
- Current High: $52.50
- Current Low: $51.00
- Previous Close: $51.75
TR calculations:
- High - Low = $52.50 - $51.00 = $1.50
- |High - Previous Close| = |$52.50 - $51.75| = $0.75
- |Low - Previous Close| = |$51.00 - $51.75| = $0.75
True Range = $1.50 (the maximum value)
Understanding ATR in Context
1. Risk Management Applications
Traders often use ATR multiples for risk management purposes. A common approach involves using ATR values to understand potential price movement ranges.
Example: For a stock trading at $100 with an ATR of $2, a 2x ATR movement would represent a $4 price change from the reference point.
2. Position Sizing Concepts
ATR can help in understanding relative volatility between different securities. Higher ATR values indicate greater price movement ranges, while lower ATR values suggest smaller typical movements.
3. Identifying Volatility Changes
Rising ATR indicates increasing volatility, often accompanying significant market events. Falling ATR suggests decreasing volatility or consolidation periods.
Observation: When ATR falls to multi-period lows, it indicates a period of reduced volatility. Markets often experience periods of expansion following periods of contraction, though the timing and magnitude of such moves cannot be predicted with certainty.
4. Comparing Stock Volatility
ATR allows volatility comparison between stocks, though it's important to consider the absolute price levels when making such comparisons. A percentage-based volatility measure may be more appropriate for comparing stocks with significantly different price levels.
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Common ATR Applications
ATR Trailing Stop Concept
The ATR trailing stop is a dynamic approach that adjusts with volatility, adapting to market conditions. This concept allows for flexibility in different volatility environments.
ATR and Breakout Analysis
Price movements that exceed typical ATR ranges may indicate unusual market activity. When a stock moves beyond its normal volatility range, it could signal a change in market dynamics, though such movements can occur for various reasons and don't guarantee continuation.
Note: A stock with a 14-day ATR of $1.50 that moves $3.00 in a day (2x ATR) is experiencing above-average volatility. This often coincides with significant news or market events.
Volatility-Based Analysis
Understanding relative volatility through ATR can help in comparing different securities and market conditions.
Comparative Example:
Consider two stocks with different ATR values:
- Stock A: Price $50, ATR $1
- Stock B: Price $200, ATR $5
While Stock B has a higher absolute ATR, when considered as a percentage of price, Stock A shows 2% typical movement versus Stock B's 2.5%.
Limitations and Considerations
Important Considerations: Understanding ATR's limitations is essential for proper interpretation:
- No Direction Information: ATR only measures volatility magnitude, not price direction
- Historical Basis: ATR is calculated from past data and doesn't predict future volatility
- Gap Sensitivity: Large price gaps can temporarily affect ATR readings
- Period Dependency: Different ATR periods (7, 14, 21 days) produce different values
- Absolute vs. Relative: ATR provides absolute price movement, not percentage-based comparisons
Frequently Asked Questions
What is a typical ATR value?
ATR values vary significantly based on the security's price level and market conditions. There's no universal standard for what constitutes a "normal" ATR. The indicator is most useful when comparing current readings to historical values for the same security.
What ATR period setting is most common?
The 14-period ATR, as originally proposed by J. Welles Wilder, remains the most widely used setting. Some analysts use shorter periods (7-10) for more responsive readings or longer periods (20-30) for smoother, less reactive measurements.
How is ATR different from standard deviation?
While both measure volatility, ATR uses the True Range concept to capture gaps and limit moves, making it particularly useful for markets with overnight gaps. Standard deviation measures dispersion from the mean using closing prices.
Can ATR predict price direction?
No, ATR is non-directional. It measures the magnitude of price movement without indicating direction. For directional analysis, ATR is typically combined with other technical indicators.
Is ATR suitable for all securities?
ATR works best for liquid securities with regular trading activity. For thinly traded securities or those with irregular price gaps, ATR readings may be less representative of typical volatility.
How is ATR used in different timeframes?
ATR can be calculated on any timeframe—daily, hourly, or minute charts. Shorter timeframes typically show lower absolute ATR values. The interpretation remains consistent: higher ATR indicates greater volatility for that specific timeframe.
Disclaimer: This article is for educational purposes only and should not be considered investment advice. ATR is one analytical tool among many and should be understood in the context of comprehensive market analysis. Always conduct your own research and consider consulting with qualified financial professionals regarding investment decisions.