Technical Analysis, Studies, Indicators:
Average True Range (ATR)
The Average True Range (ATR) indicator was developed in 1978 by J. Welles Wilder as a measurement of a security's volatility. The ATR indicator does not reflect the price direction and is not used to predict price. Nevertheless, this indicator is widely used in technical analysis to measure the degree of price movement or price volatility.
The ATR indicator attempts to take overnight trading into account for those instances in which the price of a security leaps upward at the opening of the market. In some cases, there will be a gap between the opening price of a stock or commodity and its previous day closing price, but the price will remain unchanged for the rest of the trading day. Since the difference between High and Low in this case is not large, the candle of this bar will be small, which will not reflect the actual jump in price from the precious day's close. In order to more precisely reflect the volatility of an analyzed security, Wilder suggested using the previous bar's closing price to capture gaps that would not be included by a formula that is based only on the high-low price range.
In the majority of cases, the high-low range is the largest and is used in the calculation of TR and ATR. Still, for volatile securities (that have a tendency to start trading with a gap up or gap down at the market opening) the previous day's close would be used in the TR and ATR calculations. The TR value is always positive and its absolute value should be used if the previous bar close is higher than the current bar High or lower than the current bar Low.
After the TR has been determined, the moving average is calculated. For example, an ATR(11) is an 11-bar moving average of TR. Some technical analysts use a simplified method to calculate the TR moving average. For instance, to define the ATR (11), the previous ATR (11) bar is multiplied by 10, the current bar TR value is added and the result is divided by 11.
Keep in mind that low priced stocks have lower ATRs than high price stocks (a $5 stock has a lower ATR than a $500 stock). Furthermore, it would be wrong to compare the ATR of stocks that have different price ranges.
Technical Analysis, Signals and Trading Systems
In technical analysis Average True Range is used to evaluate a security's volatility with the purpose of selecting high or low volatility stocks for trading. It is also used in stop loss and trade's exit strategies. The ATR indicator also can be very useful in the long-term trading systems to define stock market long-term trends. Plus, some traders monitor this indicator to spot radical changes in volatility with purpose of re-adjusting trading to fir new market conditions.
Using ATR to Select Stocks for Trading
It is well known that high volatility stocks offer higher potential reward. Many high risk traders are using various stock filters to select high volatility stocks for their portfolios. However, with higher volatility comes higher risk. Trading risk is always aligned with potential profit - with higher risk a trader may expect higher profit.
Click HERE to see an example of the Stock Screener which allows to select high volatility stocks
Using ATR in Stop Loss Trading Strategies
There are several trading strategies that uses ATR to define stop loss and avoid choppy trading. In less volatile market we gave small price swings and respectfully smaller stop-loss could be used. Controversially, during high volatility in order to avoid price fluctuation bigger stop loss could be recommended. In many sources you will find 3 times ATR as recommended stop-loss level. Chandelier Exit is one of the variation of using ATR as a trailing exit.
Using ATR do define long-term trends
As a rule, volatility is lover during long-term uptrends and volatility is higher during long-term down-trends, recessions and stock market crashes This characteristics could be used to define long-term trends. On the Nasdaq 100 chart below you may see period when 14-day Average True Range increased by 2-3 times. Strong increase in volatility to such high levels is an indication of the coming stock market crash in 2008.
Chart 1: NASDAQ 100 index - Average True Range (ATR).
When it comes to recognizing long-term trends, it could be recommended using Absolute ATR (ATR%) as it will not depend on a price level of an analyzed stock or index. As an example, before 1973 crash the S&P 500 index was traded around $110 and before crash in 2008 the same S&P 500 index was traded around $1500. Such, in the first case the ATR was around 2.3 points and in the second case the ATR was around 30 points. However, in both cases, prior to the crash the Absolute ATR (ATR%) was below 2% and during the crash above 2%. As you may see, the Absolute Average True Range indicator allows comparing different securities and different periods in order to find patterns.
Using ATR to calculate other technical indicators
Number of technical analysis noticed that adding volatility analysis component to other technical indicators may substantially improve output as signals could be adjusted to the volatility - less sensitive during periods of lower volatility and more sensitive during the periods of higher volatility. This union allows reducing lag without an increase in the false signals. Some of the technical indicators that use ATR in their calculations are
- DMI (Directional Movement Index) where Average True Range is used to calculate positive and negative Directional Movement Indicators.
- Bollinger Bands are using ATR to calculate bands.
- Keltner Channel uses ATR to build its upper and lower channel lines.
- Chandelier Exit uses ATR to define trailing exit for long and short trades.
Using Volatility to adjust Trading Systems.
Volatility is one of the most important characteristic describing a trend. Volatility monitoring and analysis allows to define periods of different price behavior. During the periods of low volatility (recorded during long-term up-trends), price trend changes are prolonged in time and the price corrections are small small. In opposite, during higher volatility price trends changes occurs more often and they are sharper and stronger (deeper). Furthermore, it is logical to use different indicators setting for technical indicators that are used to generate trading signals.
As an example, on the S&P 500 index chart below, you can see that, since July 2007, the S&P 500 index has been 2-3 times more volatile. This means that the price has been changing its direction 2-3 times more frequently since July 2007 then before. As a result, the technical indicator settings that were used in the period prior to August 2007 may fail to generate signals in subsequent months. The old indicator settings may simply open and close a trade when it is already too late.
Chart 1: S&P 500 index chart - 14-day Average True Range (ATR).
As you can see, the ATR helps to identify highly volatile periods. In August 2007, by having ATR data, a trader could be willing to adjust the indicators to be more sensitive to, and react more quickly to, price changes, or a trader could be willing to adjust an indicator setting to avoid stronger swings.
ATR Formula and Calculations
The calculation of the ATR is simple and consists of two steps:
Step #1: Define the True Range (TR) - The True Range is defined as the highest of the following numbers:
- The difference between the current bar High and the current bar Low.
- The absolute value of the difference between the current bar High and the previous bar Close.
- The absolute value of the difference between the current bar Low and the previous bar Close.
Step #2: Apply the moving average to the defined TR.
ATR = SMA(TR)
By Victor Kalitowski for MarketVolume.com
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