The Technical Analysis 101 blog series is your guide to understanding trading concepts, price patterns, and technical indicators. Every post will focus on a specific topic to expand your knowledge and elevate your trading game.
Exploring the Average True Range Indicator
This blog post will examine one of the most commonly used technical indicators: the Average True Range (ATR). We’ll explain how the ATR is calculated, highlight what distinguishes it from other volatility indicators, and guide traders on leveraging it to make more informed trade decisions.
What is the Average True Range (ATR)?
Developed by J. Welles Wilder, the ATR is a technical analysis indicator that measures market volatility by calculating the average range of price movements over a specific period. Unlike other volatility indicators that rely solely on price changes, ATR considers gaps and limit moves, allowing traders to understand a stock’s or financial instrument’s true volatility.
The formula for determining ATR is as follows:
ATR = (Sum of True Range values) / (Selected Time Period)
To calculate the True Range (TR), we consider the highest of the following:
- Current High minus the Current Low
- Current High minus the Previous Close
- Current Low minus the Previous Close
Now that we briefly understand the formula let’s discuss how ATR differs from other volatility indicators.
Why is ATR Different?
The primary distinction between ATR and other volatility measures is that ATR accounts for gaps and limit moves in price, allowing it to capture the true range of price fluctuations more accurately.
Moreover, ATR is a non-directional indicator, meaning that it doesn’t provide information about the direction of the trend, only the range of price movements. This makes it versatile and complementary to other technical analysis tools that offer directional insights, such as moving averages or trendlines.
How Traders Use ATR
Now that we’ve established what sets ATR apart let’s look at some practical examples of how traders use the ATR indicator.
- Determining Stop Loss Levels: By assessing the stock’s volatility, traders can set smarter stop-loss levels that account for the stock’s natural fluctuation. This reduces the risk of prematurely exiting the trade during normal market fluctuations.
- Position Sizing: Traders may use ATR to help determine position sizes. Higher ATR values suggest higher volatility, necessitating smaller position sizes to keep risk at the desired level.
- Breakout Confirmation: A sudden increase in ATR may confirm a breakout, signaling a potential buying or selling opportunity.
Bottom line
The ATR indicator’s effectiveness relies on the trader’s comprehension of market conditions and the implementation of a well-planned trading strategy. However, the ATR indicator can offer valuable insights into volatility if used correctly. It may assist in risk management and enable traders to make better-informed decisions.