Introduction
J. Welles Wilder Jr., a respected technical analyst and author of numerous books on technical analysis, created and introduced the Average True Range (ATR) indicator, a tool that is utilized in technical analysis to gauge the volatility of an asset, in his book “New Concepts in Technical Trading Systems” in 1978.
Wilder is also known for inventing other popular technical indicators such as the Relative Strength Index (RSI) and the Directional Movement Index (DMI). Wilder is widely regarded as a pioneer of modern technical analysis, and the ATR is just one of several indicators he created.
Traders use the ATR in a variety of ways, including setting stop loss and take profit orders. For instance, a trader might set a stop loss order at a specific multiple of the ATR below the current price to limit potential losses if the asset’s price moves against them. Similarly, a take profit order could be set at a multiple of the ATR above the current price to lock in profits if the asset’s price continues to move in their favor.
Additionally, the ATR can be helpful in identifying trends in an asset’s volatility. If the ATR is increasing, it may signal that the asset is becoming more volatile, which could prompt traders to adjust their strategies accordingly. Conversely, if the ATR is decreasing, it may indicate that the asset is becoming less volatile, presenting an opportunity for traders to enter or exit positions.
The ATR is a versatile indicator that traders can use to manage the risks associated with trading volatile assets. However, as with any technical indicator, traders should not rely on the ATR alone and should use it in conjunction with other forms of analysis to confirm trends and potential opportunities. Traders should also be aware that past performance is not a guarantee of future results and should use proper risk management techniques when trading.
Computing the Average True Range Indicator
The ATR, a.k.a. Average True Range, quantifies the degree of price fluctuation exhibited by an asset during a designated time frame. This calculation is done by determining the True Range (TR) for each period and then averaging these values over time.
The TR represents the level of price volatility of an asset, determined by selecting the highest value among the following three options:
- the difference between the asset’s present high and low,
- the absolute value of the difference between its present high and the previous day’s closing price, or
- the absolute value of the difference between its present low and the previous day’s closing price.
To calculate the ATR, the first step is to determine the TR for each period using the formula:
TR = max(present high – present low, abs(present high – previous close), abs(present low – previous close))
After the TR for each period is calculated, the ATR can be calculated by averaging the TR values over a specified period, such as 14 periods.
The formula for ATR is
(TR1 + TR2 + ... + TRn) / n,
where n represents the number of periods used in the calculation.
It is important to note that the ATR is typically calculated using a moving average to help smooth out fluctuations in the indicator and provide a more accurate measure of an asset’s volatility over time.
Interpreting the Average True Range Indicator
For traders, the Average True Range (ATR) is an essential tool used in technical analysis. It measures an asset’s volatility, which is essential information for managing risk and determining position sizes. Higher volatility can mean larger price swings, potentially increasing profits or losses.
The ATR can also identify trends in volatility. Increasing ATR indicates the asset is becoming more volatile, while decreasing ATR signals decreasing volatility. Traders can use this information to adjust their strategies and positions accordingly.
In addition, the ATR is useful for setting stop loss and take profit levels. Traders can use multiples of the ATR to set stop loss levels below the current price and take profit levels above the current price. The ATR can also support other technical indicators to confirm or identify trends, such as a rising ATR combined with a rising price trend indicating increasing momentum.
Furthermore, the ATR has the ability to detect possible breakout opportunities. When the ATR is low, it may indicate market consolidation, which could lead to a breakout in either direction. Traders can use the ATR to set entry and exit points for breakout trades.
The ATR is versatile and can be used on different timeframes, from intraday trading to swing or position trading. It provides valuable information on volatility trends, regardless of the timeframe.
In summary, the ATR is a vital tool for traders seeking to manage risk and take advantage of price movements in volatile markets. It provides valuable information on volatility trends and can be used with other technical indicators to make informed trading decisions.
How to use the Average True Range Indicator?
To achieve success in trading, it is recommended to use the Average True Range (ATR) in the following ways:
Determine position size
The ATR can be used to calculate the position size based on the trader’s risk tolerance. For instance, if the ATR is ₹10, and a trader is willing to risk 1.5% of their account, they can buy or sell one contract or share for every ₹666 in their account.
Set stop loss and take profit levels
The ATR can be utilized to set stop loss and take profit levels based on the current market volatility. For example, a trader can set their stop loss at two times the ATR below the entry price and take profit at two times the ATR above the entry price. This strategy limits potential losses while enabling profit-taking if the price moves in the trader’s favor.
Also see: How to set up stop loss and take profit levels in trading
Use in conjunction with other technical indicators
The ATR can be combined with other technical indicators to confirm trends and identify potential trading opportunities. A trader can look for a rising ATR combined with a bullish moving average crossover to identify a potential long trade.
Adjust the timeframe based on market conditions
The ATR can be used on different timeframes depending on market conditions. In high volatility markets, shorter timeframes may be appropriate to capture price movements, while longer timeframes may be better suited for low volatility markets. Traders should be flexible and willing to adjust their timeframe based on market conditions to maximize the effectiveness of the ATR.
Monitor ATR changes
Changes in the ATR over time can indicate shifts in market volatility. By tracking changes in the ATR, traders can adjust their trading strategies accordingly to take advantage of these shifts in volatility.
Avoid using ATR in isolation
The ATR should not be used in isolation. It is important to use the ATR in conjunction with other technical and fundamental analysis tools to make informed trading decisions. Traders should also consider the overall market environment, news events, and other factors that could impact the asset they are trading. By using the ATR as part of a larger trading strategy, traders can increase their chances of success.
Combine with fundamental analysis
The ATR can be used with fundamental analysis to make more informed trading decisions. For example, if the ATR is high, and there is a significant news event or economic report coming out, a trader may want to avoid taking a position until the news is released.
Overall, traders can use the ATR successfully and effectively by understanding its strengths and limitations and using it in conjunction with other technical and fundamental analysis tools to make informed trading decisions. They should also be flexible and willing to adjust their strategies based on changing market conditions.
Welles Wilder on the Average True Range Indicator
J. Welles Wilder Jr., credited with creating the Average True Range (ATR), had a number of insights on how traders could utilize this indicator effectively. Here are some of his key ideas:
Measure volatility with ATR
According to Wilder, the ATR is an excellent tool for gauging volatility and recognizing potential trends. By tracking changes in the ATR, traders can better understand how much an asset’s price is likely to move and make adjustments to their trading strategies accordingly.
Set stop loss and profit targets using ATR
Wilder believed that the ATR could be employed to set stop loss and profit targets based on the level of volatility in the market. By using stop loss and profit targets that are proportional to the ATR, traders can manage their risk while still allowing for potential gains.
Also see: How to set up stop loss and take profit levels in trading
Combine ATR with other indicators
Wilder emphasized the significance of incorporating the ATR with other technical indicators to validate trends and recognize possible trading prospects. He recommended using the ATR with indicators such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD).
Be mindful of ATR’s limitations
Wilder also advised traders to be aware of the ATR’s limitations, such as its tendency to lag behind sudden changes in volatility. He suggested using the ATR in combination with other indicators and keeping an eye on current market conditions to ensure that trading strategies remain effective.
Overall, Wilder believed that the ATR was a powerful tool for traders, but emphasized that it should be used in conjunction with other indicators and with an understanding of its limitations. By doing so, traders could use the ATR to measure volatility, set stop loss and profit targets, and identify potential trading opportunities with greater accuracy and confidence.
Advantages & Limitations of the Average True Range Indicator
The Average True Range (ATR) is a popular indicator used by traders to measure volatility, manage risk, and identify potential trading opportunities. However, it has its advantages and limitations that traders should be aware of.
Advantages
- Measures volatility: The ATR provides traders with an estimate of how much an asset is likely to move in price, helping them make informed decisions about risk management and position sizing.
- Helps set stop-loss and profit targets: Traders can use the ATR to set stop-loss and profit targets that are proportional to the level of volatility in the market, reducing their risk while still allowing for potential gains.
- Provides signals for potential trend reversals: The ATR can indicate whether a trend is gaining strength or weakening, which can help traders make more informed decisions.
Limitations
- Lagging indicator: Since the ATR is based on past price movements, it may not always reflect current market conditions. Traders may need to use other indicators or analysis to get a more complete picture of the market.
- Not always accurate in low volatility markets: The ATR is designed to measure volatility, so it may not be accurate in low volatility markets. Traders may need to adjust their strategies or use other indicators that are better suited to such conditions.
- Can generate false signals: Like any technical indicator, the ATR can generate false signals, especially in choppy or volatile markets. Traders should use the ATR in conjunction with other indicators and analysis to confirm trends and trading opportunities.
- May not be suitable for all markets: The ATR was developed for use in commodity futures markets and may not be suitable for all markets or asset classes. Traders should test the ATR and other indicators in their chosen markets to determine their effectiveness.
The ATR, or Average True Range, is a technical indicator with broad usage in trading. It serves as a useful tool for measuring volatility, establishing stop-loss and profit targets, and recognizing potential trading openings. Observing the ATR over time allows traders to gauge an asset’s potential price movements and modify their tactics accordingly.
While the ATR is a valuable technical indicator, it has limitations and may not consistently provide accurate or effective results in all market situations. Traders should employ the ATR in conjunction with other indicators and analysis to validate trends and trading openings, and should test the indicator in their preferred markets to evaluate its efficiency. Furthermore, traders must keep in mind that past performance is not a guarantee of future outcomes, and therefore should use appropriate risk management strategies when employing the ATR or any other indicator.
