What is the Average True Range (ATR) Indicator & How to Use it?

The Average True Range (ATR) is a technical analysis indicator developed by J. Welles Wilder in order to measure market volatility. The ATR captures the degree of price movement over a given period, providing key insights into market volatility.

ATR theoretically offers a comprehensive measurement of volatility, because it disregards gaps and limit moves, resulting in a more consistent gauge of fluctuations in price. A higher ATR indicates increased volatility, suggesting greater potential for price swings, while a lower ATR signifies decreased volatility, pointing to more stable market conditions. 

The ATR does not indicate price direction but rather the strength of price movement, making it a potential tool for setting take-profit and stop-loss levels, as well as determining trade entry and exit points. As such, ATR is often used for trade management and risk management purposes, allowing investors and traders to better align their trading strategies with prevailing market conditions.

The Average True Range (ATR) quantifies the magnitude of price movement within a specific time frame to assess market volatility. It does this by analyzing the range of price fluctuations over each period, typically 14 days, capturing the highest value among three measures: the difference between the current high and low, the absolute difference between the current high and the previous close, and the absolute difference between the current low and the previous close. 

By averaging these values, the ATR smooths out short-term volatility, and provides a clearer picture of ongoing market conditions. Traders use the ATR to assess volatility, set stop-loss levels, and determine entry and exit points. The ATR provides insight into market volatility, but it doesn’t provide insight into price direction.  

To calculate the Average True Range, one must first determine the true range for each period within the specified timeframe. The true range is the greatest value among the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close. 

Once these true ranges are calculated, the ATR is derived by averaging them over the selected number of periods, typically 14 days. This averaging process helps smooth out the data, providing a more consistent measure of volatility and allowing traders to better gauge market conditions.

More details on the ATR formula are highlighted below.

First, the true range (TR) for each period is calculated. The true range is defined as the maximum of the following three values:

• The current high minus the current low.

• The absolute value of the current high minus the previous close.

• The absolute value of the current low minus the previous close.

Mathematically, the true range can be expressed as:

TR=max(Current High−Current Low,∣Current High−Previous Close∣,∣Current Low−Previous Close∣)

Once the true range values for each period are determined, the ATR is calculated by averaging these true ranges over a specified number of periods, typically 14. The ATR for a given day is computed as follows:

ATRt = [(ATRt−1×(n−1))+TRt]/n 

Where: 

• ATRt is the ATR for the current period.

• ATRt−1 is the ATR for the previous period.

• TRt is the true range for the current period.

• N is the number of periods over which the ATR is being calculated (commonly 14).

This formula ensures that the ATR reflects both recent and past volatility, smoothing out short-term fluctuations and providing a more reliable measure of market conditions.

The following information provides a hypothetical example of average true range, and how to calculate it.

Imagine a stock exhibits the following behavior over a 3 day period: 

• Day 1: High = $50, Low = $45, Close = $47

• Day 2: High = $52, Low = $46, Close = $50

• Day 3: High = $55, Low = $48, Close = $54

Step 1: Calculate the True Range (TR) for each day

Day 1

• Current High - Current Low: 50−45 = 5

• There is no previous close to compare, so the True Range for Day 1 is simply 5. 

Day 2:

• Current High - Current Low: 52 − 46 = 6

• Absolute value of Current High - Previous Close: ∣52−47∣ = 5

• Absolute value of Current Low - Previous Close: ∣46−47∣ = 1

• True Range: max⁡ of (6,5,1) = 6

Day 3:

• Current High - Current Low: 55−48 = 7

• Absolute value of Current High - Previous Close: ∣55−50∣ = 5 

• Absolute value of Current Low - Previous Close: ∣48−50∣ = 2

• True Range: max⁡ of (7,5,2) = 7

Step 2: Calculate the Average True Range (ATR)

If calculating the ATR over the 3 days provided, the ATR for Day 3 would be the average of the True Ranges of Days 1, 2, and 3, as outlined below:

ATR = (TR on Day 1 + TR on Day 2 + TR on Day 3)/number of periods

ATR = (5+6+7)/3 = 18/3 = 6

Per the above calculation, the ATR over the three days is 6. This value indicates the average range of price movement over the selected timeframe, providing a measure of the stock's volatility during this period.

The Average True Range (ATR) provides insight into market volatility, reflecting the magnitude of price movement over a given period.

In the previous example, an ATR of 6 indicates that, on average, the price of the stock has fluctuated by 6 units per day over the three-day period. This example illustrates how the ATR measures the intensity of price movement in the underlying asset without indicating the direction of those movements, making it a valuable tool for managing risk.

Traders can use the insights gleaned from the ATR to set trade entry or exit points and to establish take-profit or stop-loss levels. In this regard, the Average True Range is beneficial from both a trade management and risk management perspective, enabling traders to make more informed decisions based on prevailing market conditions. 

The Average True Range (ATR) is a vital tool for traders and investors, offering a helpful measure of market volatility. This indicator assists in the assessment of market activity over a set timeframe. 

Using the ATR, investors and traders can set more precise entry and exit points for their trades, aligning their strategies with the prevailing levels of market volatility. The ATR also aids in determining appropriate take-profit and stop-loss levels, which are essential for effective risk management. 

Incorporating the ATR into trading and investment decisions theoretically allows for improved decision-making, enabling market participants to navigate volatile markets with greater confidence, and allowing them to optimize their strategies for improved outcomes.

There isn't a universally "good" Average True Range (ATR) because its significance varies based on a trader's or investor's specific goals and strategies. The ATR is a measure of volatility, so its interpretation hinges on the market participant's intended approach, goals, and risk profile. 

For instance, a high ATR indicates high volatility, which may be advantageous for day traders or swing traders looking for significant price movements to capitalize on short-term opportunities. In contrast, long-term investors, or those with a conservative risk appetite, may prefer a lower ATR, which would be indicative of a more stable price environment, and lower volatility.

The ATR is also helpful when it comes to tailoring one’s risk management approach to prevailing market conditions. For example, in a high volatility market, one might set wider stop-losses, to avoid being prematurely stopped out by prevailing price fluctuations. Conversely, in a low volatility market, tighter stop-losses may help protect against smaller, but still significant, adverse price movements.

Overall, the ATR helps market participants align their strategies with current market dynamics, ensuring their risk management and strategic approaches are appropriate for the level of volatility they are dealing with. In this regard, insights provided by ATR can help investors and traders maximize potential returns and minimize potential risks - no matter the market environment.