Average True Range (ATR)
Introduction Developed by J. Welles Wilder (1978). The Average True Range (ATR) indicator measures a security's volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility.
As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind. In 1978, commodities were frequently more volatile than stocks. They were (and still are) often subject to gaps and limit moves. (A limit move occurs when a commodity opens up or down its maximum allowed move and does not trade again until the next session. The resulting bar or candlestick would simply be a small dash.) In order to accurately reflect the volatility associated with commodities, Wilder sought to account for gaps, limit moves, and small high-low ranges in his calculations. A volatility formula based on only the high-low range would fail to capture the actual volatility created by the gap or limit move.
Wilder started with a concept called True Range (TR) which is defined as the greatest of the following:
•The current High less the current Low.
•The absolute value of the current High less the previous Close.
•The absolute value of the current Low less the previous Close.
If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, it is likely that one of the other two methods would be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move). To ensure positive numbers, absolute values were applied to differences.
The example above shows three potential situations when the TR would
not be based on the current high/low range. Notice that all three
examples have small high/low ranges and two examples show a significant
gap.1.A small high/low range formed after a gap up. The TR was found by calculating the absolute value of the difference between the current high and the previous close.
2.A small high/low range
formed after a gap down. The TR was found by calculating the absolute
value of the difference between the current low and the previous close.
3.Even
though the current close is within the previous high/low range, the
current high/low range is quite small. In fact, it is smaller than the
absolute value of the difference between the current high and the
previous close, which is used to value the TR.
Note: Because the
ATR shows volatility as an absolute level, low price stocks will have
lower ATR levels than high price stocks. For example, a $10 security
would have a much lower ATR reading than a $200 stock. Because of this,
ATR readings can be difficult to compare across a range of securities.
Even for a single security, large price movements, such as a decline
from 70 to 20, can make long-term ATR comparisons difficult.
Calculation
Typically, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first TR value in a series is simply the High minus the Low, and the first 14-day ATR is the average of the daily ATR values for the last 14 days. After that, Wilder sought to smooth the data set, by incorporating the previous period's ATR value. The second and subsequent 14-day ATR value would be calculated with the following steps:
1.Multiply the previous 14-day ATR by 13.
2.Add the most recent day's TR value.
3.Divide by 14.
Calculation
Typically, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first TR value in a series is simply the High minus the Low, and the first 14-day ATR is the average of the daily ATR values for the last 14 days. After that, Wilder sought to smooth the data set, by incorporating the previous period's ATR value. The second and subsequent 14-day ATR value would be calculated with the following steps:
1.Multiply the previous 14-day ATR by 13.
2.Add the most recent day's TR value.
3.Divide by 14.
Basic signals:
If today's high is above yesterday's high and
today's low is below yesterday's low, then today's high-low price range
is used as the true range (the first alternative above).
If
yesterday's close is greater than today's high or is less than today's
low, then it signals a gap or limit move, and one of the other
alternatives apply to determine the true range to use in calculating the
ATR. At the beginning, the first TR value is simply the high minus the
low, and the first 14-day ATR is the average of the daily TR values for
the last 14 days. After that, the data is smoothed by incorporating the
previous period's ATR value.
Strong trending moves, whether up or
down, often include large price ranges or large true ranges, especially
at the beginning of a move. Consequently, ATR can be used to help
determine the enthusiasm behind a move or provide reinforcement for
acting on a breakout.
Pro/con: ATR provides a better gauge
of a market's recent price range and volatility over a given period.
However, for markets that trade continuously around the clock, a steady
stream of prices may reduce the need for the ATR indicator. ATR also
does not provide any guidance on price direction.
