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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.
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.
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 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
The following steps explain the calculation of ATR:
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.
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.
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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