What Is the Average True Range (ATR)?

The average true range (ATR) is a technical analysis indicator. Market technician J. Welles Wilder Jr. introduced this concept in his book "New Concepts in Technical Trading Systems." This indicator decomposes the whole price range for a specific period to measure market volatility. The true range indicator is the greatest of the following:

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;

The ATR is then a moving average of the true ranges, often using 14 days. More trading signals could also be generated using a time period smaller than 14 days. On the other hand, longer periods result in the generation of fewer trading signals.

How does ATR works?

High ATR values with each bar getting larger in range suggest a boost in the market volatility. On the other hand, an increase in ATR with a reversal in price suggests that the move is strengthening. Since ATR is non-directional, an expansion in ATR indicates buying or selling pressure. High ATR readings are typically the outcome of a rapid uptrend or downtrend and are not likely to last for an extended time.

Low ATR values suggest the presence of a series of periods with small ranges. The prolonged sideways price action that produced these low ATR values caused lower volatility. Low ATR values for an extended length of time could be a sign of consolidation and the potential for a move or reversal to continue.

ATR is highly helpful in indicating changes in volatility for entry or stop triggers. The ATR stop will adjust to sharp price changes or consolidation zones, which might cause an anomalous price movement in either direction, unlike fixed dollar-point or percentage stops, which do not allow for volatility.

Limitations of the ATR

The usage of ATR indicator comes with two limitations, which are as follows:

The first limitation is that ATR is a subjective measurement, which means it can be interpreted in several ways. No single ATR number can predict whether the trend is poised to reverse or not. To gauge a trend's strength or weakness, ATR readings should constantly be compared with earlier readings.

The second limitation is that ATR measures only volatility. It doesn't consider the direction of an asset's price. It could occasionally lead to mixed signals, especially when markets are experiencing pivots or approaching turning points.

How can you Read ATR Values?

The average price range of an investment over a given time period is known as an average true range value. As a result, if an asset's ATR is $1.18, its price has an average daily range of fluctuation of $1.18.

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