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.
The calculation of the ATR is simple and consists of two steps:
Step #1: Define the True Range (TR).
Step #2: Apply the moving average to the defined 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.
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.
Chart 1: NASDAQ 100 index - Average True Range (ATR).
The ATR indicator can be very useful in trading systems to define stock market periods of high volatility. In the chart above, you can see that, since August 2007, the NASDAQ 100 index has been 2-3 times more volatile. This means that the NASDAQ 100 price has been changing its direction 2-3 times more frequently since August 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.
As you can see, the ATR helps to identify highly volatile periods. In August 2007, by having ATR data, a trader who is proficient in technical analysis would adjust the indicators to be more sensitive to, and react more quickly to, price changes.
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