History
J. Welles Wilder Jr. developed the Average True Range (ATR) technical indicator in the late 1970s. Wilder also introduced other widely used technical indicators, including the Relative Strength Index (RSI) and the Average Directional Index (ADI), commonly known as ADX.
The Average True Range (ATR), another creation of Wilder, serves as a tool to gauge market volatility, aiding traders in spotting possible shifts in trends.
Definition
ATR is a technical indicator that measures the volatility of a financial asset. It is calculated by averaging the True Range (TR) over a specified time period.
The True Range is the largest of the following values: the difference between the current high and low, the difference between the previous close and the current high.
Meaning
A technical analysis indicator called the Average True Range (ATR) gauges an asset’s volatility over time. High ATR values indicate that the asset is volatile, whereas a low ATR value indicates that the asset is not volatile.
Who uses ATR?
1. Day traders: ATR is frequently used by day traders to set stop-loss orders and profit targets for intraday trades. They can use ATR to get a sense of the stock’s volatility and set appropriate levels for their trades.
2. Swing traders: Swing traders, like day traders, can use ATR to set stop-loss orders and profit targets over a longer time frame. They may employ ATR to assist them in determining when to enter and exit a trade.
3. Position traders hold their positions for an extended period of time, often weeks or months. They may employ ATR to assist them in determining entry and exit points, as well as setting stop-loss and profit targets.
4. ATR is used by technical analysts as part of their technical analysis toolkit. They may employ ATR to assist them in identifying trends and confirming other technical indicators.
5. Algorithmic traders may use ATR as part of their trading algorithms to help them make automated trading decisions based on stock volatility.
How to calculate?
The formula to calculate the ATR range is relatively simple:
ATR range = ATR value x Multiplier
| Day | High | Low | Close | TR | ATR |
|---|---|---|---|---|---|
| 1 | 50 | 40 | 45 | 10 | 10 |
| 2 | 55 | 35 | 40 | 20 | 11.43 |
| 3 | 60 | 45 | 50 | 15 | 12.38 |
| 4 | 55 | 40 | 50 | 15 | 12.09 |
To compute the TR for each day, we must first determine the daily range. This is simply the difference between each day’s high and low prices.
Each day’s daily range needs to be calculated:
Finding True Range with maximum values
1. The difference between today’s high and today’s low
2. Today’s maximum minus the previous day’s close
3. Today’s low minus yesterday’s close
Calculating Daily True Ranges
Day 1: 10
Day 2: max(55 – 35, abs(55 – 45), abs(40 – 35)) = max(20, 10, 5) = 20
Day 3: max(60 – 45, abs(60 – 40), abs(50 – 45)) = max(15, 20, 5) = 20
Day 4: max(55 – 40, abs(55 – 50), abs(50 – 40)) = max(15, 5, 10) = 15
Calculating Average True Range with formula
ATR = [(Prior ATR x 13) + Current TR] / 14
Day 1
Due to the fact that this is the first day, the previous ATR is simply the same as the TR for Day 1, which is 10. As a result, the ATR for Day 1 is also 10.
Day 2
The ATR is calculated using the formula above on Day 2. The previous ATR is Day 1, which is 10, and the current TR is 20. Upon inputting these values into the formula, the result is obtained as follows:
ATR = [(10 x 13) + 20] / 14 = 11.43
Day 3
On Day 3, we use the same formula, but this time the prior ATR is the ATR from Day 2 and the current TR is 20. Plugging these values into the formula yields:
ATR = [(11.43 x 13) + 15] / 14 = 12.38
Day 4
For Day 4, we use the same formula with the prior ATR being the ATR for Day 3 and the current TR being 15. Plugging these values into the formula, we get:
ATR = [(12.38 x 13) + 15] / 14 = 12.09
Interpretation
Meaning
The ATR values in the table represent the stock’s average range of price movement over a 14-day period. A stock’s volatility increases with a higher ATR.
In this example, the ATR values range from 10 to 12.38, indicating that the stock’s price has moved between 10 and 12.38 points per day on average over the last 14 days.
Volatility
This means that the stock has experienced moderately large price swings. However, it is important to remember that volatility is a relative measure, and what is volatile for one stock may not be volatile for another.
Average True Range Calculator
What can traders do with this knowledge?
• Set stop-loss orders: Traders can use the ATR value to place stop-loss orders at various distances from the current price level. To limit potential losses, a trader may set their stop-loss order 1.5 to 2 times the ATR value away from the current price level if they believe the stock will move by an average of 11.28 points per day.
• Determine Profit targets: Traders can also use the ATR value to determine potential profit targets. Based on their experience, a trader might set a profit target of 1.5 to 2 times the ATR value above the current price level.
Using ATR for Risk Management and Trade Planning:
Traders find the Average True Range (ATR) invaluable for risk management and strategic trade planning. By understanding an asset's volatility through ATR, traders can implement effective strategies:
1. Optimal Stop-Loss Placement
With the ATR value, traders can calculate suitable distances for stop-loss orders. Setting stop-losses at a multiple of the ATR away from the current price helps safeguard against sudden price swings, aligning risk tolerance with potential loss.
2. Profit Target Determination
ATR aids traders in establishing profit targets. By gauging an asset's potential price movement based on ATR, traders can set realistic profit-taking levels that correspond to the expected volatility.
3. Position Sizing
ATR can guide traders in adjusting their position sizes. Volatile assets may require smaller positions to control risk, while less volatile ones can accommodate larger positions.
4. Trade Entry and Exit
Traders can utilize ATR to time their entries and exits. Entering a trade during periods of higher volatility can enhance the chance of capturing substantial price movements, while exiting when volatility drops can secure profits.
5. Options Trading
ATR assists options traders in selecting appropriate strike prices and expiration dates. High ATR values may warrant wider strike ranges to accommodate potential price swings.
6. Volatility-Adaptive Strategies
Incorporating ATR into trading strategies helps adapt to changing market conditions. Traders can adjust their approach based on ATR values, optimizing their strategies for varying levels of market volatility.
What are Average True Range volatility guidelines?
A higher ATR value generally indicates higher volatility, while a lower ATR value indicates lower volatility. As a result, what constitutes a good or bad ATR depends on the investor's risk tolerance and trading style.
Traders who prefers high-risk, high-reward trades, for example, may think a high ATR is good, whereas a more conservative investor may think a low ATR is good.
An ATR value of less than 0.5% of an asset's price is considered low or quiet, while an ATR value greater than 1% is considered high or volatile. A medium ATR may be in the 0.5% to 1% range of an asset's price.
Conclusion
Finally, the ATR is a versatile technical indicator used in financial analysis to measure volatility and identify potential price movements. ATR is calculated using the true range, which takes into account the difference between an asset's high and low price, as well as any gaps in the trading range.
This method provides a more accurate picture of an asset's volatility than other methods that only take closing prices into account.
FAQ
How to use Average True Range on Thinkorswim
Thinkorswim is a popular trading platform offered by TD Ameritrade, which provides a range of technical indicators, including the Average True Range (ATR).
Follow these steps to use the ATR indicator in Thinkorswim:
1. In Thinkorswim, open a chart for the security you want to examine.
2. At the top of the chart window, click the "Studies" button.
3. Choose "Add Study/Compare" and type "ATR" into the search bar.
4. In the search results, select "Average True Range" and then "Add Selected" to add the indicator to your chart.
5. The ATR line will appear on the chart, and you can adjust the indicator's settings as needed.
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