Average true range or ATR is a technical indicator popularly used for tracking the volatility of a particular market. This technique uses a specific timeframe for indicating any movement in the asset value. By using ATR as an indicator, a broker can decide to buy or sell the security at a certain price point.
An ATR indicator can be a helpful analytical tool for a market investigation. Thus detailed knowledge about the same can come in handy.
What is an Average True Range (ATR) indicator?
A true average range or ATR indicator is a popularly used analytical tool for a market investigation. It works by tracking and measuring the degree of volatility in a particular market.
The ability to track market volatility is what makes ATR indicator different from other technical tools, which measure the trends of pricing in a particular market.
This technique was first introduced by J. Welles Wilder Jr., a technical analyst, in his book “New concepts to technical trading system” in 1978.
Initially, J. Welles recommended a 14-period smoothing as a representation by the ATR indicator. Later, it was replaced by an N-period smoothed moving average (SMMA) of the true range values.
How to use ATR indicator for technical analysis?
To be able to make a sound and well-analyzed decision in trading, it is necessary to be familiar with the indicator you are dealing with.
How the ATR indicator works is by measuring the movement of the prices in a particular market on an average. Primarily, three methods are used for defining what True Range values are.
- Method 1: Current high less the current low. This method is used when the candle depicting current has a larger range than the previous one.
- Method 2: Current high less the previous low. This method also depicts the absolute value. It is used when the closing on the current candle is higher than the previous candle.
- Method 3: Current low less the previous low. This method also depicts the absolute value. It is used when closing on the current candle is lower than the previous candle.
Thus, for ATR, the larger the candle ranges, the greater will be the Average True Range value.
How to calculate the Average True Range Value?
As originally stated by J. Welles, the ATR is based on 14-periods. It can be calculated daily, weekly, intraday, or every month.
For calculating the first true range value, the low is subtracted from the high. This value is calculated for 14 days straight. The ATR is then calculated by taking an average of the daily true range values, calculated for 14 days.
The formula for current ATR appears as follows:
The value so obtained can either be positive or negative. Only the higher absolute value is used in the calculation.
How can the Average True Range be beneficial for the traders?
As mentioned earlier, the ATR indicator helps analyze the volatility of a stock in the market. Therefore, if a stock is highly volatile, the ATR value will be high, and if the stock has lower volatility, the ATR value will be low.
Studying the volatility can help the trader decide on the best time to either exit a trade or put a stop loss to take a profit.
- Exiting a trade is when you decide to sell your stock and get out of trading. This decision can be very crucial in terms of analyzing your gains and losses. Therefore, using an ATR indicator can give you a clearer picture.
- Stop-loss, as the name suggests, helps in minimizing an investor’s losses. A stop-loss order is placed, for buying or selling of stocks, when the stock reaches a certain price point. An ATR indicator, by studying the volatility of the stock, can provide you an analysis as to whether it is the right time for placing a stop-loss order.
ATR is mainly used for placing stop-loss orders. While doing so, if you are buying a stock, multiply the ATR value with two and use that value as a mark to put a stop-loss below the entry price. And if you are selling a stock, you do the same, but above the entry point price.
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For instance, if a long trade is taken at 1000 and the ATR value is 20, then you put the stop-loss at;
Another benefit that comes with the ATR indicator is that it helps understand a trade’s potential for profit. For instance, it can help guide the investor into placing a closer take profit on a market with low volatility, and stretch it in case the volatility spikes.
What is an Absolute ATR?
The volatility reflected by the ATR indicator is in terms of an absolute value. Therefore, a stock with a higher price point in the market will have a higher ATR value, while a stock with a lower price point in the market will have a lower ATR value.
It is not indicated in terms of the percentage of the current stock.
For instance, a stock priced at 200-300 will have a higher ATR value than the stock priced at 20-30.
What are the limitations of ATR?
There are mainly two limitations of an ATR value.
- Since ATR is a measure of volatility, it does not give any directional indication for the stock prices.
- The interpretation of ATR is not exhaustive. There lies no certainty in a single ATR value for depicting the trends in the market. It cannot help determine if there is a possibility of reversal of trend or not. For instance, an increased ATR value might appear to be a confirmation of the return of an old trend, which might actually not be the case.
This means the ATR value cannot be used as the solitary indicator for understanding market trends. Even though it a terrific tool for understanding the market dynamics, it should be paired with other technical indicators to getter a better understanding of the market trends.
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