Average True Range Indicator (ATR): Formula & Calculation

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Synopsis:

Average True Range (ATR) is one of the most powerful indicators of price volatility in the capital market. It can help traders determine whether the volatility has increased or decreased, which can allow them to take trading calls.

Introduction to Average True Range

Average True Range or ATR is a popular technical indicator that is used in the capital market to measure volatility in the price of assets. This measure was first introduced by J. Welles Wilder Jr. who developed it for commodities.

This could be because commodities witness higher volatility in their prices than shares. However, over the years, ATR has been used for stocks and indices as well. ATR shows the average range in the prices of an asset over a specific period. ATR is only a measure of volatility. It only shows whether an asset’s price has been more or less volatile in a certain period. It does not indicate whether the price is going to increase or decrease.

Now that we have learned the full form of ATR in the stock market, and also have some idea about it, let us dig deeper.

What is the Average True Range?

Average true range (ATR) measures volatility in the prices of commodities and stocks and also in the value of indices. If the value of ATR is high, it means the volatility in price is high. Conversely, if the ATR’s value is low, it shows that the volatility in price is low. ATR is a powerful indicator in the stock market.

As per ATR, the true range of the price of an asset is the highest of the following: today’s high price minus today’s low price, the absolute value of the difference between today’s high price and yesterday’s closing price, and the absolute value of today’s low price minus yesterday’s closing price. Then, a moving average of the true ranges over 14 days is calculated to estimate the ATR.

The Average True Range (ATR) Formula

The ATR formula is given below:

Current ATR = [(Prior ATR x (n-1)) + Current TR)]/ n   – ATR Formula 1

In this formula:

‘n’ stands for the number of periods. Typically, we take 14 days as ‘n’ to calculate ATR.

‘Current TR’ is the true range of the price in the current period.

‘Prior ATR’ is the average true range of the price in the previous period.

‘Current ATR’ stands for the average true range of the price in the current period.

In the event, that we take 14 days as a period, ‘n’ will be equal to 14, and ‘n-1’ will be 13.

However, suppose the prior ATR is not provided, how to calculate Current ATR, then? In that case, you can calculate the Current ATR using the following formula:

[(Summation of the true range of the price over a period)/n]   – ATR Formula 2

Understanding ATR Calculation

The following steps explain the calculation of ATR:

  • ATR stands for the average of the true range of the price of an asset over 14 days. 
  • To calculate it, you need to estimate the true range of the price by using the method explained in this section: What is the Average True Range?
  • By doing this, you will have 14 values of the true range for 14 days. Now, you will have to add these values and divide the result by 14 to calculate its simple average to arrive at the ATR. This method is captured by Formula 2 in the previous subsection.
  • If you have been given the value of prior ATR, which means ATR for 14 days immediately preceding today, then the first thing you should do is estimate the true range today.
  • Then, you need to multiply the prior ATR with this fraction 13/14. By doing this, you are converting the 14-day value into a 13-day value. Now, how do we make it a 14-day value?
  • For this, you need to first divide today’s true range by 14. And, then add the resultant value to the value you got in the previous step. This method of ATR calculation is captured by Formula 1 in the previous subsection.

Importance of ATR Indicator

  • The Average True Range indicator is extremely useful to help you spot abnormal price movements in either direction. It is a powerful indicator for trading online.
  • As ATR considers the previous day’s closing price as well, it is a much more comprehensive measure of volatility than the price range for a specific day. 
  • For example, let us say that a stock’s high price was Rs. 110 and its low price was Rs. 105 today. So, its price range today is Rs. 5. But, what if its yesterday’s closing price was Rs. 102? By considering the difference between yesterday’s closing price and today’s high and low prices, ATR provides a more realistic measure of volatility.

Example of How to Use the ATR in Trading

  •   ATR indicates whether the price is moving up or down rapidly or slowly. However, it does not tell us the direction of price movement.
  •   Suppose a stock’s ATR is Rs. 30. For the next few days, the ATR remains in the range of Rs. 30-33. This shows that the volatility is not increasing or decreasing rapidly. A sideways trend in the price is likely here.
  •   However, after a few days, the ATR suddenly jumps to Rs. 45, indicating that volatility has gone up. As the volatility is high, the price can break out from this pattern.
  •   At this moment, you should consider other indicators to decide whether you should buy or sell the stock. Remember that ATR alone cannot tell you to buy or sell because it does not tell you in which direction the price will move.

What Is a Good Average True Range?

  • A good ATR depends upon the security under consideration and also the situation.
  • Before finalising a good ATR, you should check an asset’s ATR over the recent past.
  • For example, suppose its ATR has remained at around Rs. 100. However, now, its ATR is 120, then it may indicate something.
  • Similarly, if the ATR falls much lower than Rs. 100, then also you should find out the reason behind it. For example, if ATR falls to 83, you need to check why the volatility is so low.

     

  • Once you have figured out a good ATR value (e.g., Rs. 100 in this case), the rest of the analysis falls into place.

Advantages of The ATR

  • The biggest advantage of the ATR is that it helps traders understand whether volatility is rising or decreasing.
  • If volatility is increasing, there is a possibility of a strong upward or downward trend in the price of a security.
  • On the other hand, if volatility is decreasing, it indicates that a trend is becoming weak.
  • The other advantage of the ATR is that it is reasonably simple to calculate. ATR calculation does not require you to use complex maths or any complex tool. That said, you will not be required to calculate it because many trading platforms provide the value of indicators like ATR.

What Does The ATR Indicator Tell You

ATR’s full form in the stock market is the average true range, which is an indicator of volatility in the price of an asset. It shows the average variation in the price for a given period. If the ATR of an asset suddenly increases, it indicates that the volatility is rising. It could be that either its price is going to increase or decrease at a sharp rate, which means that there could be a trading opportunity here.

Besides, apart from considering today’s high and low prices, ATR also considers the previous day’s closing price. As a result, it takes into account even the gaps in price movements. Therefore, it is quite a comprehensive indicator. And, when it is correctly used with other indicators, it can help traders generate significant returns.

Strategies Using Average True Range

  • To trade with ATR, you can use something called ‘ATR bands’.
  • You can create ATR bands by either adding or subtracting a multiple of ATR to an asset price’s moving average.
  •   For the upper band, you can add two times of ATR to the moving average. For the lower band, you can deduct two times of ATR from the moving average.
  •   The upper and lower limits of these bands have a considerable difference between them. When the price moves outside of these bands, it is a signal that you may have to think of your trading strategy.
  • For example, if volatility is high, a trader may decide to use a wider stop-loss order to earn profits earlier than he typically does.

Limitations of Average True Range

Having learned the full form of ATR in the stock market, let us now discuss its limitations. First, like most indicators, it is open to interpretation. Often, two traders interpret a single value of the ATR in two different ways. Besides, a single value of ATR cannot tell you whether a trend is going to reverse or not. Therefore, you should compare its value with earlier values to understand the trend in volatility.

Second, ATR is an indicator of only volatility. It does not indicate the direction in which the price may move. Therefore, a trader needs to know how to use ATR with other indicators because on its own ATR may not be able to tell what needs to be done.

Conclusion

Average true range or ATR is an indicator of price volatility in the stock market. It can be used for many asset classes, like shares, commodities, and indices. It can provide valuable signals to a trader. However, traders need to understand that it is a subjective measure. Therefore, they need to be a bit careful while drawing interpretations based on it. However, when ATR is used with other indicators in the stock market, it can reveal powerful insights that can help traders make money.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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