Do you know what the ATR indicator is?
The Average True Range (ATR indicator) or True Average Range, is a measure of volatility created by J. Welles Wilder Jr, in his book New Concepts in Technical Trading Systems, in 1978. As a curiosity, its creator is the creator of technical indicators as famous as the Relative Strength Index (RSI), Average Directional Index, and the Parabolic SAR.
A stock’s range is the difference between its high and low price on any given day. Reveals information about the volatility of a trading asset. Large ranges indicate high volatility and small ranges indicate low volatility. This ATR indicator is applied in the same way on commodity futures and options, as it is for stocks in the world of trading.
At the time this indicator was designed, one of the main differences between stock and commodity markets was that major futures exchanges try to avoid extremely erratic price movements by putting a cap on the amount a market can move in a single day (maximum volatility).
How is the ATR calculated?
In trading, to calculate the ATR indicator (Average True Range) we must start from the calculation of the True Range, which was developed by Wilders to address the above problem by accounting for the gap and more accurately measure daily volatility and price deviations, than was possible by simply calculating the range.
The True Range is the largest value of the result of the following 3 equations
- TR= High – Closing of the previous day
- TR= Close of the previous day- Low
- High: Represents the high of the day
- Low: represents the low of the day
The mid true range (ATR indicator) is an exponential moving average of the true range. Wilder used a 14-day ATR to explain the concept. Traders can use shorter or longer timeframes depending on their preferences when trading the market. Longer timeframes will be slower and likely lead to fewer trading signals, while shorter timeframes will increase trading volume.
How to interpret the ATR?
The ATR indicator does not necessarily indicate the exact moment of a trend reversal, although it can spot trend momentum in the market, and offers help in trading and measuring daily volatility. To identify entry and exit points or directions effectively in trading, other indicators such as relative strength index and moving average convergence divergence should be considered.
Its interpretation would be the following:
- High values of the ATR indicate high activity in the market and, therefore, that the movements that occur are of a wide range (volatility). Very high values occur as a result of a large rise or fall and it is very unlikely that the ATR will remain at high values for long.
- Low ATR values indicate little activity, a calm market in which movements will be short.
- Prolonged low ATR values indicate price consolidation and may be the starting or continuation point of a trend.
Trading strategies using the ATR
1.- With momentum strategies
If a stock is in an uptrend and the ATR indicator starts to rise (increased volatility), it means that price fluctuations are increasing, which may indicate a reversal. This is a good trading signal.
two.- With support and resistance
The ATR indicator (Average True Range) can also be used to confirm a trend. If a lower support line breaks, indicating a downtrend, a trader can confirm the strength of bearish sentiment if the ATR has risen.
3.- With Bollinger Bands
Another example of application would be its combination with one of the most well-known indicators such as Bollinger Bands. If the ATR indicator increases at the moment that prices are above the upper band, it indicates an upcoming change in trend.
4.- ATR Multiples
Many traders build their systems using the ATR or a multiple of the ATR. This trading system consists of adding that value to the price of the following day and buying when prices move above that level.
5.- To define stop loss
To place the stop loss point you simply calculate the distance between your entry +/- the value of the ATR at that moment. If we want to place a stop loss on the market based on the ATR, we will place it at factor*ATR. The stop loss, as you know, is essential when operating and essential in trading.
The ATR indicator (Average True Range) is a versatile trading tool that helps traders measure volatility and can help us trade and make better entry and exit decisions. A complete trading system can be implemented using only this indicator.