Technical indicators help traders to analyze past market trends and forecast future developments. While some traders develop personal indicators, usually with a programmer’s help, others rely on existing ones. As a result, indicators like the moving average and stochastic oscillator, or bespoke indicators, are becoming more popular among traders. ATR is also a widely used indicator that helps analysts determine market volatility. This article discusses the ATR indicator in detail.
What Is the Average True Range (ATR)?
Founded by American technical analyst J. Welles Wilder in 1978, Average True Range (ATR) is a volatility indicator that displays how much an asset changes on average. The technical indicator may assist day traders in deciding whether to enter a trade and where to set stop-loss order. Analysts calculate it by dividing the price range of an underlying asset over a specific period.
How Does Average True Range (ATR) Indicator Work?
The ATR indicator swings up and down when an asset’s price changes. Each period generates a fresh ATR measurement. For instance, the ATR is calculated daily on a one-day (D1) price chart, while it shows the ATR value every minute on a one-minute (M1) time frame.
Formula For ATR Calculation
ATR measures volatility by accounting for price gaps. Typically, traders calculate ATR using 14 periods, such as Minute (M1), Hour (H1), Day (D1), Week (W1), or Month (MN). Each one can calculate ATR. We have the following formula to calculate ATR.
The TRi represents a particular true range in this formula, and “n” shows the relevant period.
How to calculate the Average True Range (ATR)
Finding a security’s actual range value is the initial step in determining ATR. A security’s price range is just its high minus low. Traders can produce more trading signals by employing shorter periods, whereas longer intervals provide fewer indications.
For instance, if you are a short-term trader and want to look at a stock’s volatility over five trading days, you might compute the five-day ATR. Then, for each price range, you determine the absolute maximum of each, such as current high-current low, current high- previous close, and current low-previous close. That’s how you calculate ATR for the most recent 05-days and then average the value to find the first value of 5-day ATR.
What does Average True Range (ATR) Indicator Tell You?
Wilder created the ATR to employ it in the commodity market, but it is equally helpful to trade equities and indexes.
The ATR is a valuable tool for market technicians to initiate and exit trades. Its primary purpose was to help traders calculate an asset’s daily volatility more precisely. However, traders mostly use it to assess volatility generated by gaps and restrict up or downswings.
Traders typically employ ATR to exit a trade regardless of the entry point. One of the popular strategies is called the chandelier exit strategy developed by Chuck LeBeau. The chandelier exit establishes a trailing stop below the stock’s highest high since you opened a position.
In simple terms, the distance between the highest high and the stop level is the multiple of ATR. For example, you can deduct three times the ATR from the trade’s highest point since you entered.
The ATR may also help traders decide how much to trade in a derivates market. The ATR technique to position size can account for both the trader’s risk tolerance and the market’s volatility.
Example of Using the Average True Range (ATR)
Assume the five-day ATR starts at 1.41 and ends at 1.09. You can estimate the sequential ATR by multiplying the former ATR value with the number of days minus one and then adding the current period’s actual range.
Now divide the total by the chosen period. For instance, [1.41*(5 – 1)+(1.09)]/5 is expected to be the second ATR value. You may then use the formula throughout the entire timeframe.
ATR can not predict the breakout direction, but you can add it to the closing price, which will help you enter a buy position if the price rises over that figure the next day, as shown below. Rare trading indications generally mark big breakthrough moments. According to this theory, a price closing the ATR above the previous close indicates a shift in volatility. Buying a stock means you expect it to rise.
Limitations of Average True Range (ATR) Indicator
The ATR indicator comes with two significant limitations.
- Being a subjective measure, ATR remains open for interpretation. No ATR measurement can tell you if a trend is poised to reverse or continue in the same direction. Instead, you must compare ATR values to previous readings to gauge a trend’s intensity.
- ATR gauges volatility, not price direction, and may produce confusing signals, especially when markets or trends pivot. For example, a quick rise in the ATR after a strong move against the market trend may cause some traders to believe the ATR supports the previous direction when this is not the case.
Unlike RSI or MACD, ATR isn’t a trend indicator. Instead, it’s a volatility indicator that shows the degree of interest or indifference in a move. Large ranges, or True Ranges, typically accompany strong movements. Uninspiring maneuvers might have limited spans. As a result, traders may utilize ATR to verify a market move or breakout. A rise in ATR would imply significant buying pressure and confirm a bullish reversal. A bearish support breach with an increase in ATR would ensure the support break. Like other indicators, ATR can also lead to false interpretation, and traders must not depend solely on it. Therefore, it’s usually best to use along with technical tools and indicators for additional confluence.
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Frequently Asked Questions (FAQs)
Which indicator works best with the ATR indicator?
The Average True Range measures volatility. However, It is typically neglected as a market indicator since it indicates price action strength. Bollinger Bands are well-known indicators that may work the best with ATR.
How is Average True Range (ATR) helpful for traders?
Being a volatility indicator, ATR offers you an idea of how much the market may change. Day traders can use ATR with different technical indicators and strategies to find optimal entry and exit positions.
Which number is more suitable for the Average True Range (ATR) indicator?
Although it isn’t the only technique, the conventional ATR indicator number is 14. You can also consider using a lower number to emphasize recent volatility. More significant numbers allow long-term investors to measure more.