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Average True Range (ATR)

What is the Average True Range?

The Average True Range (ATR) indicator is a volatility indicator that was developed by John Welles Wilder, Jr., and was introduced in his book, New Concepts in Technical Trading Systems, of 1978. The ATR is used to measure the volatility, or the degree of price movement, of a security. In other words, it measures the extent to which the price action can be expected to fluctuate. This measure of fluctuation, or volatility, is then smoothed by being averaged over a specified time period, with the default period being 14.

The Average True Range (ATR) indicator was originally developed for commodity trading, which is frequently subject to gaps and limit moves, and thus, the ATR takes into account gaps, limit moves, and tight high-low ranges in order to determine the true range of a commodity. Although the ATR was designed for commodity trading, it can also be used to for other securities or financial instruments, such as stocks and derivatives such as single stock futures (SSFs), ForEx, and index futures, etc.

The ATR indicator is based on absolute price values rather than on percentage changes. Therefore, a security with a higher price tends to have a higher ATR than a lower priced security. As a result, the ATR cannot be used to directly compare two or more securities or financial instruments.

The ATR indicator also does not provide an indication of price or trend direction. It is solely a measure of the volatility of the security or financial instrument. When the ATR for a security is high, then that security is considered to be more volatile; and when the ATR is low, then the security is considered to be less volatile, regardless of the direction in which the price is moving.

How to calculate the ATR Indicator?

There are two steps involved in the calculation of the ATR indicator.

First, the true range (TR) of the security is calculated by determining the larger of the trading range (High − Low); the absolute difference between the current high and the previous close; and the absolute difference between the current low and the previous close. This value represents the true range for the current period. In mathematics, the absolute value of a real number is the (non-negative) magnitude of that number regardless if it is positive or negative. The absolute value of a number is denoted by two vertical pipes surrounding the number, such as |x|.

High − Low

| High − Previous Close |

| Low − Previous Close |

Then, the TR is smoothed using Wilder's Smoothed Moving Average (WSMA). The formula with the smoothing is as follows:

ATR = ( Previous ATRn-1 + TR ) ÷ n

How to trade with the ATR Indicator?

As mentioned earlier, the ATR does not indicate price nor trend direction; it only indicates an increase or decrease in price volatility. As a result, the ATR cannot provide entry or exit points for a trade. However, the ATR indicator can be used to confirm price break outs, and can be used to determine stop loss placement and position sizing for a trade.

Price Breakouts

When volatility increases from a low base, it indicates that the price range for the security under analysis is increasing. When this happens, it often marks the beginning of a significant price movement. In other words, as volatility increases, the possibility of a price break out increases, as strong price break outs, and strong price movements, are often accompanied by larger price ranges. This makes the ATR a useful tool that can be used to confirm a price break out: if the ATR is increasing, the support for a price breakout is also increasing. Conversely, if the ATR is decreasing, then the support for a price breakout is also decreasing.

This makes the ATR indicator especially useful when it is used in conjunction with a trendline pattern, such as a Head and Shoulders pattern, or an ascending triangle, etc., as the ATR indicator will help to confirm the validity of the breakout when the price breaks out of the pattern.

Trade Management

The ATR can also be used in Trade Management strategies, as a guide to dynamically determining stop loss placement and position sizing.

Stop Loss Placement

Generally, a security with a higher ATR will require a greater stop loss margin, which is often set as a multiple of the ATR for that security. A popular use of the ATR is an exit method known as the Chandelier Exit that was developed by Chuck LeBeau and introduced in Alexander Elder's book Come Into My Trading Room in 2002. The chandelier exit is used as a trailing stop loss mechanism where a multiple of the ATR is subtracted from the highest high for the lookback period in an uptrend; and a multiple of the ATR is added to the lowest low for the lookback period in a downtrend.

Position Sizing

The ATR can also be used to implement better position sizing, based on the volatility of the security being traded. This can be implemented on a per trade basis, as well as at the portfolio level.

When the volatility of a security is high, the trader should place smaller trades to maintain a reasonable risk/reward ratio, as the stop-loss (risk) would be further away. At the portfolio level, position size would be determined by the percentage of trader's account they are willing to risk. This can be calculated by simply dividing the percentage of trader's account they are willing to risk by the security's ATR and multiplying it by the price of the security, using the formula:

Position Size = Percent of account to risk ÷ ATR × Price

Chart Example

The following chart shows a 13-period ATR in the lower chart panel on a 30-minute chart of the Dow Jones Industrial Index.

Advantages and Disadvantages of the Average True Range Indicator

ATR FAQ

What is the ATR Indicator?

The ATR indicator is a market volatility indicator based on a simple moving average of a security’s price range. A relatively higher ATR implies increased volatility.

Can the ATR be used to trade cryptocurrencies and forex?

Yes, the ATR can be used in all types of markets, including cryptocurrencies, forex, stocks, and commodities.

Can the ATR be used set position sizes and stop-losses?

Yes, the ATR is ideal for setting position sizes and stop-losses as it indicates the extent of the volatility that drives the price action. As volatility increases, the ATR increases, allowing traders to expand their stop-loss placement to a multiple of the ATR to account for the increased volatility.

What is a good ATR multiplier?

In most cases, a multiplier of between 1.5 × ATR and 2.5 × ATR would be ideal to avoid price fluctuations (noise).

Summary

The ATR is a useful technical indicator that can be used to measure the volatility of a security or financial instrument. It is based on absolute price values, and thus, cannot be used to compare the volatility of different securities or financial instruments. It also does not provide an indication of price or trend direction, and therefore, cannot be used to generate entry or exit signals for a trade. However, the ATR can be used to confirm price breakouts, and can be used to determine stop loss placement and position sizing for a trade.

As the ATR does not generate trade entry or exit signals, it cannot be used as a standalone indicator and is best used in conjunction with other technical indicators and chart patterns. The popular indicators that can be used in conjunction with the ATR include the Parabolic SAR, MACD, and Bollinger Bands.