What is Average True Range (ATR)?

The Average True Range (ATR) is a technical analysis indicator used to measure volatility in financial markets. Developed by J. Welles Wilder Jr., this indicator is particularly useful in volatile markets such as Forex, commodities, and stock CFDs to determine the strength and level of price fluctuations. 

The calculation involves averaging the true range values over a specified period, usually 14 periods. The true range is determined by selecting the largest of the following three values: the difference between the current period's high and low prices, the difference between the previous closing price and the current period's high price, and the difference between the previous closing price and the current period's low price.

In this article, you can gain more detailed information about the Average True Range.

How Does the ATR Work?

ATR is a non-directional indicator, so when it expands, it can indicate both selling pressure and buying pressure. High values usually result from a sharp rise or fall and are unlikely to persist for long periods.

A low ATR value indicates a series of periods with small ranges, signifying lower volatility. Prolonged low values can indicate a consolidation area and the possibility of a continuation move or reversal.

ATR is very useful for stop levels or entry triggers. While fixed dollar points or percentage stops do not account for volatility, ATR stops adapt to sharp price movements or consolidation areas, which can trigger abnormal price movements in either direction.

How to Calculate the ATR?

ATR measures how wide price movements are over a specified period (typically 14 periods). To calculate it, you first need to determine the true range for each period.

To calculate the true range, follow these steps:

• Determine the difference between the current period's high price and low price.
• Determine the difference between the current period's high price and the previous period's closing price.
• Determine the difference between the current period's low price and the previous period's closing price.

The True Range Formula:

TR = max([Current High − Current Low, |Current High − Previous Close|, |Current Low−Previous Close|])

Then, the Average True Range can be calculated:

• Sum the true range values of the first 14 (n)* days and divide by 14. This gives the initial ATR value.
• To calculate the ATR values for subsequent days, multiply the previous ATR value by 13, add the current day’s true range value, and divide by 14. 

The Average True Range Formula:

ATR=(n1​)∑i=1n​TRi​

*n represents the number of periods

**TRi​ is the true range for each period i.

What Does the ATR Tell You?

The ATR indicator helps traders understand the level of market volatility and the strength of price movements. When the value is high, it indicates large price fluctuations and increased volatility in the market. This situation suggests that there may be strong buying or selling pressure and that a distinct trend is present in the market.

A low ATR value indicates that price movements are limited to a narrow range and volatility is low. This may suggest a period of consolidation or uncertainty in the market.

It is also used to set stop-loss levels and optimize risk management strategies. Using ATR to set wider stop-loss levels during periods of high volatility can help investors protect themselves from abnormal price movements.

Here's an example of an ATR chart:

Example of How to Use the ATR

As an example of using ATR, let's examine the true range for a 14-day period together:

Next, we need to calculate the true range (TR) for each day:

 Let's sum up the highest values for the 14 days:

1.50 + 1.50 + 1.20 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 + 1.50 = 20.40

To calculate the initial ATR value, we divide this total by 14:

20.40 / 14 = 1.46

To calculate the ATR for the current period:

• Previous ATR value (1.46) * (14 - 1) +  Today's TR value (1.50) / 14
• 1.46 * 13 + 1.50 / 14 = 18.98 + 1.50 / 14 = 20.48 / 14 = 1.46

Therefore, in this example, the average volatility for the asset is $1.46.

Importance of the ATR

• ATR is used to measure the strength and volatility of price movements in the market.
• Investors can use ATR values to determine stop-loss levels.
• It helps investors identify entry and exit points in the market, especially to evaluate the strength and continuation of a trend.
• It is a tool used in developing various trading strategies. For example, in swing trading or day trading, ATR can be used to estimate the potential range of price movements.

Limitations of the ATR

• Although ATR measures the strength and volatility of price movements, it does not provide information about the direction in which the price will move.
• It is based on previous price changes, making it a lagging indicator.
• It can be more useful during periods of high volatility, but it may give misleading signals during periods of low volatility.
• ATR calculations depend on the accuracy and reliability of the data sets used.
• While it is helpful in understanding price movements in the market, it is not sufficient to make investment decisions on its own.

FAQ on Average True Range

How do you read ATR values?

ATR values are read by looking at the numerical output of the ATR indicator on a chart. Higher ATR values indicate increased volatility, meaning larger price movements within a given period. Conversely, lower ATR values indicate lower volatility and smaller price movements.

How is ATR used in Forex trading?

In Forex trading, ATR is used to measure market volatility and to set appropriate stop-loss levels. Traders use ATR to determine the average range of price movements for a currency pair.

What is the best period setting for ATR?

The most common period setting is 14, as suggested by the creator of the ATR, J. Welles Wilder Jr. However, shorter periods like 7 or 10 can be used for more responsive, short-term trading, while longer periods like 20 or 50 can be used for a smoother, long-term perspective.

Is ATR suitable for day trading?

Yes, ATR is suitable for day trading. By understanding the average range of price movements within a trading day, day traders can make more informed decisions about entry and exit points.

How can ATR be used to identify potential breakouts?

ATR can be used to identify potential breakouts by highlighting periods of increased volatility. When values rise, it indicates that price movements are becoming more significant, which could signal an upcoming breakout.

What are the common mistakes traders make when using ATR?

Common mistakes include relying solely on ATR without considering other indicators, using an inappropriate period setting that doesn't match the trading strategy, and misinterpreting high ATR values as a definitive indicator of market direction. Additionally, traders might set stop-loss levels too close to the current price, not allowing enough room for typical market fluctuations.