Average true range (ATR) is an indicator that measures volatility in an asset – how much an asset moves- on average for a specific period of time.
It helps traders to identify or confirm whether they should enter a trade or not. It can also be used to calculate where they should put a stop loss (SL) order.
The ATR indicator is moving along to the price change, up when the price goes up or down the price goes down. For example, on a one-minute chart, a new ATR will read the price movement every one minute when on a daily chart a new ATR will read and calculate the price movement every day and so on according to the time-frame chart you choose. All the calculation is formed in a trend line to enable traders to read the volatility change of a specific asset.
In order to calculate ATR, you must first identify and read a series of true ranges (TRs). The TR for a specific period of time has as follows:
The highest value is what will be used in the calculation, whether it’s negative or positive.
The values will be recorded for a specific period of time let’s assume 10 days, and then the average value of these 10 days will be used.
The best period of time to use is 14 days. J. Welles Wilder Jr. the founder of ATR used the following formula to calculate the different periods of time after the 14 days were formed to help him in the calculations.
Current ATR=(Prior ATR*13+Current ATR) / 14
Traders can use the information about the stock price movement in a specific period by placing profit targets to check an entry or an exit.
Example: Assume a stock moves $3 on average, no fundamental news is out today but the stock is already up by $3.5. The trading change (high minus low) is $4.05, the stock price has already changed by 35% more than the average. This gives you the buy signal you were waiting for.
Analyzing that the price is already up than the usual average can indicate a potential short/sell position. The price is higher than usual and is very likely to drop in order to touch the normal price if fundamentals news or breaking positive news didn’t occur in the day.
Note: Entering or exiting a trade based on ATR alone is not suggested. ATR should be used in conjunction with other indicators for a more valid and formed opinion.
To explain the example above, you shouldn’t simply enter a short position only because the price is higher than usual. If you had a valid sell signal or news in the market that could support this decision you should use ATR to confirm your trade. Overall, you should take into consideration the historic ATR of the stock because maybe what you see as too high could be already established in a different time period.
The reason is very simple. As soon as the major U.S market opens at 9.30 am, you will notice ATR moving upwards in the first couple of minutes. This is happening because ATR gets hit by the transition from a closed(nonvolatile) market to the open(volatile)market. The open is always the most volatile time of the day!
Note: If you take your target profit as mentioned above and divided it by the ATR it will give you the minimum minutes that will usually take for the price to hit your target price.
In other words, if again you are looking at a one-minute chart and the ATR is 0.03 meaning that is moving about 3 cents per minute you can expect the price to rally up to 15 cents after 5 minutes if of course, you are bullish about this trade! If you are bearish, you can expect the price to go down by 15 cents after 5 minutes and vice versa.
In general, ATR is very helpful when used with other indicators for traders and investors. However, it has two main limitations that you should be aware of. The first, if you must have already understood it is a very subjective indicator. Which is why it allows us to interpret how we feel about the stock, bullish, or bearish as mention before. In other words, is open for interpretation. Can it guarantee me an entry?
No, it can not guarantee an entry or an exit and cannot tell you whether the price will go up or down which is why you need to figure it out. It can give you the value that the price is moving on average, but it cannot predict whether it will go up or down, only by how much it will change.
Secondly, and a bit more confusing, ATR measures only the volatility, not the direction the asset’s price is moving to. For instance, when the market is facing pivots the ATR may face a sudden increase, making you think that it is actually confirming the previous trend, when in fact this is not the case.
ATR – Average True Range is an indicator to indicate an asset’s volatility in the market. It can also indicate entry and exit points, but it should be used alone. Despite its shortcomings, such as giving mixed signals and not indicating the direction of the trend, it is useful to traders for confirming a potential trade. Using it to calculate a higher average true range shows higher volatility. Conversely, a lower one shows lower volatility and volatility is very important for technical analysis implementation.
Well done!!! You’ve made another great step towards understanding stock trading better. Try learning another term, like Parabolic SAR!!