Average True Range is a volatility indicator from J. Welles Wilder that measures the commitment (eagerness of buyers or sellers to continue their behaviour in response to changing market prices) of buyers and sellers by comparing the ranges of successive trading days. Expanding or contracting ranges help indicate the willingness of market participants to push prices to extremes during trading sessions. The ATR indicator attempts to measure this trader enthusiasm to predict reversals after panic buying or selling activity.
True Range is calculated as the greater of:
- Absolute value (High for the current period less the Low for the current period)
- Absolute value (High for the current period less the Close for the previous period)
- Absolute value (Close for the previous period and the Low for the current period)
Because there must be a beginning, the first TR value is simply the High minus the Low.
The first 14-period ATR is the average of the period TR values for the last 14 periods. After that, Wilder sought to smooth the data by incorporating the previous period's ATR value.
Current ATR = [(Prior ATR x 13) + Current TR] / 14
- Multiply the previous 14-period ATR by 13.
- Add the most recent period's TR value.
- Divide the total by 14
Trading using the ATR indicator
High ATR indicator readings are typically given during periods of heated buying or selling activity. They can therefore indicate potential trend changes at market tops and bottoms. Low readings are given during long periods of sideways movement during market consolidations indicating ranging markets.
Divergence and Convergence patterns between the price action and the ATR indicator values may also be considered. Contracting ranges after large price moves may indicate traders losing confidence in the momentum of the move as the new price levels should have been expected to gain additional trader participation and entice greater ranges.
Alternatively traders may wish to monitor potential price breakouts by observing the ATR indicator showing patterns of increasing ranges during periods of low directional price movement.
Unfortunately the ATR offers only limited information regarding price direction and trend duration. It is most useful for measuring extremes of positioning, in both trends and range patterns. It can be a very volatile indicator and is best deployed with rigid risk controls and other indicators (i.e. trend indicators) to prevent trade whipsaws.