Average true range (ATR) is one of the commonly used trading indicators in the financial business. It has become the go-to indicator for the traders who have their trading systems built around volatility.
The average true range is one of the simplest indicators to use given the fact that you can calculate the average true range for yourself or if you are more on the efficiency basis you can apply the ATR indicator that is already coded into the trading platform.
What is Average True Range (ATR) Indicator?
The average true range is mainly based on volatility and volatility is important because of it because it enables the trader know how an asset fairs given its price movements, and this can be used to determine the entry for one’s trades and the exits alike.
For traders who trade price action, this is one of the best tools to have incorporated into your system, every price action trader who understands price will always have a clear understanding of how far price may expand to and that can be seen clearly when it comes to applying the average true range.
It should be known to anyone who may want to use the average true range that this indicator does not give the direction to which price may gravitate towards but simply the volatility or price expansion to either direction.
The man, who created this indicator was called J. Weller Jr., and he introduced this indicator to the rest of the technical analysts in the book “New concepts in Technical Trading Systems.”
In the book the average true range is discussed in depth and some of the characteristics of the indicator that jump out and are the most important are; the current highs and the current lows and the absolute values calculated from the highs and lows that have closed from the past price action.
To get the absolute values in order to calculate the average true range you have to do the following. Before getting to that, it is important to know how the average true range came to be in the first place; it was built around the methods derived from finding the true range.
The first method to be used to find the true range was using the current high less the current low, the second method was what was used to find the absolute value; you take the current high and less the previous close and the third method was done by taking the current low less the previous close and that way you would still get the absolute value.
All the above methods are put together in a rather simple formula to calculate the average true range.
Calculating the Average True Range
To calculate the average true range, you require information especially prior price action to calculate the average true range given the period you want to acquire information on. As encouraged by Wilder, the 14-day period is the most efficient to use on this, and thus you will get and expected amount of movement on average over the 14-day period.
Also, the time frame in which you focus on matters a lot too, for a better broader view the daily chart is important because as a trader you get to know how much an asset moves on average on any day.
This is how it is broken down; there must be a start that is the True Range (TR). Which can be obtained by the high less the low, the first average true range based on the 14 day period used to collect the data is the average of the daily true range of the previous 14 days.
To calculate the current average true range, you will need the previous average true range multiplied by 13 and then added to the current true range and the total divided by the 14 day period.
That will be your current average true range, and this will be smoothed data because of the incorporation of the previous average true range, this gives the data continuity.
Understanding the Average True Range Indicator
The average true range is absolute in the sense that it uses the absolute change in price to get the change in price. That is why the average true range is not noted as a percentage rather as values generated from the true range.
For this reason, there is no way different assets will have the same average true range because each asset has a different pricing, they might be closely correlated, but they will have different average true ranges.
For this reason, the higher priced stocks have a higher average true range compared to the lowly priced assets and that is why there is an allure to trade the highly priced stocks based on the average true range rather than the lowly priced ones.
That is why the average true range cannot be used as a basis for comparison when doing your analysis on a given priced asset.
That is why the average true range is only used for volatility and not for price direction. The ATR is one of the best tools to use when refining down the assets you want to trade; it can be used as a sieve, and this will give you a choice to trade a lesser number of assets and thus minimize noise and maximize on the reward.
It is also a handy tool used in line with the moving averages. If the moving average shows a trend the average true range will have massive gains too to confirm there is movement in price, and when the price is ranging the average true range will be fluctuating, and this is proof that there is not much of a price movement.
Lastly, the average true range is a measure of interest, and this is one of the things that make it very likable because it confirms whether there are good opportunities or not.