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Average True Range

Parameters

  • Periods: The number of periods used to calculate the average true range, commonly set to 14. This measures market volatility by analyzing the range of price movements over the specified period.

Style:

  • Customizable line style and color for the ATR line.

The Average True Range (ATR) is an indicator used in technical analysis to assess market volatility. It does this by breaking down an asset\'s price range over a specified period. J. Welles Wilder Jr. originally developed it for commodities, but it has since been applied to all securities. The ATR does not provide price direction information but gives traders insights into the degree of price volatility within a market.

How ATR Works: The true range for each period is first determined when calculating the ATR. The valid range is the greatest of the following:

  • The current high is less than the current low.
  • The absolute value of the current high is less than the previous close.
  • The absolute value of the current low is less than the last close.

The actual range is thus the most extensive range considered over a single period, accounting for gaps that can occur between periods, especially in markets that close overnight or over the weekend.

Once the true range for each past 'n' period (typically 14) is determined, an average is taken to produce the ATR. Initially, this might be a simple arithmetic mean, but most commonly, the ATR is calculated using a smoothing technique similar to that used for moving averages:

ATR = [(Previous ATR × (n - 1)) + Current True Range] / n

Key Aspects of ATR:

  • Volatility Measurement: The ATR indicates interest or disinterest in a move. A high ATR indicates increased interest and broader price movements, while a low ATR indicates disinterest and narrower price movements.
  • Non-Directional: The ATR does not indicate the direction of the trend, only the volatility.
  • Adjustable Period: The 'n' period over which the ATR is calculated can be adjusted according to the trader's needs. A lower 'n' makes the ATR more sensitive to recent price action, while a higher 'n' makes it less sensitive.

Application of ATR: Traders use the ATR to adjust their trading approaches during different volatility levels:

  • Setting Stop Losses: The ATR can be used to set stop losses by allowing a position enough wiggle room to avoid market noise but not so much that an excessive loss occurs.
  • Position Sizing: Traders might adjust their position size based on the ATR to manage risk effectively. During periods of higher volatility, they might reduce position sizes to maintain a consistent risk level.
  • Entry and Exit Points: ATR can also help traders to determine entry and exit points. For example, breakouts beyond the average price range can indicate a new trend during low volatility periods.
  • System Development: Systematic traders may use ATR as a component for an overarching trading system, primarily to adapt systems for changing market conditions.

Limitations:

  • Historical Data: Since the ATR is based on historical data, it does not predict future volatility or price direction.
  • Lagging Indicator: The ATR can lag because it is based on past data, so sudden spikes in volatility may not be immediately reflected.
  • Absolute Values: ATR provides an absolute volatility value, which may not always be comparable across different securities with vastly different prices.

Conclusion: The ATR is a valuable indicator for assessing market volatility and can be used across various market conditions and trading instruments. Understanding and applying the Average True Range (ATR) allows traders to adjust their strategies to suit the prevailing volatility conditions. Nevertheless, it's essential for traders to integrate the ATR with additional indicators and analytical techniques to develop a robust trading strategy. The flexibility of the ATR in managing risk and responding to market changes makes it an invaluable resource for both beginner and seasoned traders.