Average True Range (ATR) Indicator: Definition & How It Works?

Average True Range

What enables traders to book profits in a stock market is the price movement. No matter how much it is frowned upon, you have the best chance to earn big when the price moves higher. But this is helpful only when the price moves favorably. Otherwise, you will end up losing money rapidly.

Hence, predicting the stock market becomes very important. Usually, a good understanding of markets and fundamental analysis coupled with technical indicators is a good way to try and predict the price action.

A true average range (ATR) indicator is a tool that you can use here. Unlike most other indicators, the average true range indicator tried to measure volatility instead of momentum. Let us learn more about average true range (ATR) indicators and see how you can make use of the same to pocket some profit from the stock market.

What is the Average True Range?

What is the Average True Range

An average true range (ATR) indicator is one of the common technical trading indicators commonly used as a part of a day trading strategy. The indicator is simple, and hence, it is beginner-friendly as well.

What makes the indicator different from other indicators is the fact that it doesn’t give you a buy or sell signal. Instead, it focuses on measuring the maximum price movement on either side.

The average true range indicator is developed by Welles Wilder. A mechanical engineer turned real estate legend. He is also known for his expertise in technical indicators. He has invented a number of technical trading systems, and the average true range indicator is one of the most common.

As said above, ATR is different from most other technical indicators. But is it even a trading indicator? If not, what is it? Let us explore.

Is ATR Indicator a Trading Indicator?

A trading indicator gives you trading signals to help you maximize your profits. It does this with the help of mathematical formulas and references to history. Let us take the example of pivot points, a trading indicator, to explain this better.

Is ATR Indicator a Trading Indicator

Here, the black line is the pivot line, and the red line is the resistance line. Here, you can see that the price touching these lines and bouncing back. Hence, a trader, after confirming with another trading indicator, uses this bounce as a buy/sell signal appropriately.

Now, look at the below picture.

Is ATR Indicator a Indicator

This picture shows a price chart above and the ATR graph below. Here, you can see that the average true range indicator graph movements have no direct relation to the price changes above.

This is because instead of momentum, an average true range indicator calculates the maximum possible price movement at any point in time. This helps traders set their entry price and exit prices according to their trading strategy.

Relation of ATR and Volatility

Here, the ATR measures volatility. Volatility is the possibility of changes in the stock price due to fluctuations over a period of time. It helps the day traders understand the risk and return potential of security and trade accordingly. For instance, if you are an aggressive trader who is trying to make use of the chances of high volatility, you could look for a stock in which the ATR indicator shows a higher chance of volatility. At the same time, if you are looking for a less risky trade, you could look for a stock in which the average true range shows a lesser volatility chance. One thing to understand here is that the higher the risk, the more the potential and vice-versa.

How to Calculate ATR?

ATR is simply is average of true ranges for a certain period of time. It can be created for daily, monthly, and even quarterly charts.

Usually, 14-period data is used for the ATR indicator. But you can choose any number of data periods, according to your strategy. Most trading platforms show a 14-period average true range indicator data by default.

Coming back to calculation, you first need true ranges for the above-mentioned 14 data period. Let us focus on intraday trading today and take the true range values for the last 14 days. The true range values are the highest of the following for each period.

Current high – Current low

Current low – Previous close

Current high – Previous close

Then an average is taken by dividing the true range values by 14 since we have taken 14-period data.

For instance, let us suppose the true ranges for are –

  • 40
  • 42
  • 44
  • 38
  • 36
  • 38
  • 39
  • 41
  • 50
  • 30
  • 35
  • 42
  • 34
  • 40

Then the average true range would be a total/14. That is approximately 44.8. This is the average true range for this period.

For the subsequent periods, you can use the equation –
New ATR reading = [Prior ATR value * 13 + Current True Range] / 14

How to Read ATR?

How to Read ATR

Take a look at the one-day chart of Life Insurance Corporation of India (LIC). The above is the price graph, and below is the average true range indicator graph.

Now, volatility indicators are differently represented in a graph compared to momentum indicators. A momentum indicator going up or down usually represents a price action and gives you a buy or a sell signal.

Here, the below graph of ATR is independent of the price movement and instead, it tells you the maximum expected price fluctuation at that given point in time. Hence, the ATR value is what matters more when you look at an average true range ATR indicator on its own. The spikes in the graph could show the volatility increase and are useful when clubbed with trading indicators when creating a strategy.

Now let us take a deeper look at the image.

Read ATR

Here, pay close attention to the point marked with a blue cross signal. The exact moment is June 22, 2022, at 9.17 am, just a few minutes after the market has opened. You can see the price value here at Rs.666.40 and the ATR value at Rs.1.82. That means, at this point in time, the maximum price fluctuation expected is Rs.1.8. Now, look at how the graph has gone up closer to Rs.669, making the ATR indicator prediction true. Here, you can see that the ATR number has helped more than the graph.

High and Low Volatility Signals

The ATR indicator represents the maximum predicted price change of a security. Hence a higher number means a higher chance for volatility. At the same time, it is impossible to compare one stock’s ATR values to another because different stocks as it is dependent on the asset’s price as well.

High and Low Volatility Signals

The above picture shows the price and the daily ATR chart of Reliance Industries. Here, as you can see, the ATR is Rs.4.05, and the stock price is Rs.2554.60. Now, look at the picture below.

High and Low Volatility Signals 2

Here is the price and ATR setting for Delhivery on a particular day. Here, the current ATR value is Rs.3.78, and the stock price is Rs.489.20.

In the scenario, the ATR values of both companies are similar, but the stock price of Reliance is very high compared to Delhivery’s. Hence, a price change of about Rs.4 is not the same for both. Because of this, make sure you consider the stock price as well before making your move.

Now that it is clear what the ATR indicator is let us understand how we can put it to use.

How to Use ATR in Trading?

As we have discussed above, the ATR indicator helps you gauge volatility, i.e. the maximum predicted price change. Now, an important thing to understand here is that you should use a trading indicator to gauge where the momentum of the price change.

For instance, the ATR could be 2 for a stock, but you need to be able to predict which way the price change is going to happen. Considering that you have a trading indicator ready, let us take an example to understand the ATR indicator and strategies better.

Now, let us assume you bought a stock which is currently priced at Rs.100 and has an ATR of 30. With a trading indicator, you confirmed that the momentum is showing an uptrend, so your options are buying and longing the stock.

For ease of understanding, let us assume that you decided to buy the stock. Let us also assume the ATR remains the same throughout the example.

You bought the stock at Rs.100 (reminder – the ATR is 30), and it hit Rs.110 after a short spike. Now, will you sell at this point? Of course, you will need to confirm the trend direction using another indicator, but the consensus is that the maximum price change possible if the price moves favorably are 30. Hence, you could wait for a little longer to exit the trade.

Let us assume that the stock’s price went down a bit. Will you sell at this point? Ideally, you should have set a stop-loss, but considering you haven’t, if the trend direction is still positive, you could still wait for the stock to go up and hit the profit target.

Now, what will you do if the price breaks the ATR prediction and hits Rs.131? Considering the ATR remains the same and only shows 30, it would be a wise decision to sell and pocket the profit at this point.

Breakouts

Markets usually move in different volatility cycles. There is always a quiet period before the price goes up or down because of an increase in volatility.

Look at the area denoted by the arrow in the below price graph.

Breakouts

You can see here that before the price drops down, there is a period of steadiness. Such sudden movements are called breakouts, and identifying the ‘quiet’ period before a breakout is helpful in making the most of them. The ATR indicator can be used to identify the same.

For this, you have to find multi-year low volatility (ATR) time frames first. Take a look at the below picture.

Breakouts 2

The graph shows historical stock price and ATR value data of WIPRO from 2006 to now. Here, pay attention to the area marked by the red line. The graph shows that this is the lowest point ATR has gotten to in a long time. Let us now take a closer look at the same chart.

Breakouts 3

Here, you can see the area marked with the crosshair where the low ATR point happened. Shortly after that, you can see two things – a sudden increase in volatility and price. Buying at this point could have given you some profit.

Using a Signal Line

Throughout this article, you have seen how helpful ATR indicators are in setting exit trades. But how good are they in helping you identify an entry price?

Well, the average true range indicator is only a volatility indicator, and ATR on its own is not efficient for the same.

But if you club your ATR indicator strategy with a trading indicator, it could help you find the entry price as well. One such indicator is a moving average.

Here, you can add a moving average line over the ATR-enabled chart and look for a cross. When there is an uptrend, and the ATR line crosses above the signal line could confirm a bullish trend, and you could place an aggressive strategy.

On the other hand, if the if the ATR line crosses below the signal line, it could confirm a bearish trend. Here, you could sell your shares or open a shorting position.

Position Sizing

Position sizing is a strategy that traders use for risk management. Different investors have different risk appetites. The idea here is to choose a position size according to the average true range value (volatility) to manage risk better.

For instance, if you are a conservative trader, you could choose a smaller position size if the average true range value is higher, thus limiting the amount of risk you take.

Trailing Stop-Loss with Average True Range Value

Many traders set a stop-loss to avoid losing money rapidly. A trailing stop-loss is an upgraded version of the same. A trailing stop-loss helps you set a stop not at a specific price point but at a percentage level.

Here, Traders can use ATR value to figure out where to put their trailing stop-loss. When you enter a trade, make a note of the current ATR level. Generally, experts believe that a number twice the ATR value is a good point to set stop-loss. Then set the same as your trailing stop-loss point. Now, the stop loss will work in both directions, helping you avoid losses more effectively.

Conclusion

The average true range is a useful indicator that helps you trade better and minimize risks. Among all the complex tools, an ATR manages to remain simple – a higher ATR means higher volatility and vice versa.

But, as discussed above, make sure you couple the ATR indicator with a trading indicator as well for best results.

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