Definition of Average True Range (ATR)
The average true range (ATR) is a technical analysis indicator that measures market volatility by decomposing the entire range of an asset price for that period. The true range indicator is originally designed for use with commodities markets but has since been applied to all types of securities.
To understand what Average True Range represents, we need to first understand what ‘true range’ is. True range is used to describe the price movement and hence volatility of a security within a specific time period, and is taken as the greatest of the following:
- Current High minus Current Low
- Current High minus Previous Close (absolute value)
- Current Low minus Previous Close (absolute value)
The Average True Range, as its name suggests, is simply the arithmetic average of the true ranges over a specific number of periods, usually 14. The indicator can also be viewed as the simple moving average of the true ranges.
Intuitively, ATR essentially measures the average daily movement/volatility of the price of a security. Note that the ATR measures the volatility in the same measurement unit as the security price. Also note that ATR does not reflect the direction of security price movement, but rather it only measures the range of price movement.
Example: reading the ATR
Consider Figure 1, the latest ATR reading is around 0.0042. This means that over the past 14 days (since Figure.1 a daily chart and the period setting for ATR is 14), the average daily movement in the price of AUD/USD is 0.0042 in USD. In general, a security experiencing a high level of volatility has a higher ATR reading, and a low volatility security has a lower ATR.
2 ways of integrating ATR into your trading
The first way to use ATR is to simply check the ATR reading, and use that number to determine your stop loss and take profit levels. As mentioned before, a security experiencing higher volatility will have a higher ATR reading. Consider a situation where a trader sets the stop loss too tight (i.e. only a few points or pips above current price), that high volatility security can easily trigger the stop loss even when the security is just fluctuating as usual. Hence, ATR allows a trader to take into consideration the price volatility of a security when setting a stop-loss.
Building on the first point, by reading the ATR traders can also gain insights into approximately how much margin they need in their account when trading a certain security.
The second way is to use ATR to determine point of entry in a market. This is more widely used in a volatility-based trading strategy. The underlying belief here is that securities tend to move from a period of low volatility to high volatility. This method involves the following steps:
- Check if the ATR is near historical lows
- Check the price chart to determine whether the security is whipsawing in a confined price range (as opposed to be in a clear trend)
- If ATR is near historical lows and there is no clear trend in the price chart, then it means the trend has yet to begin and the trader should wait for a breakout as the signal to enter into the market
- When the breakout happens (i.e. decisive close above resistance or below support), it tends to start a clear trend with rising volatility in the upcoming periods. This presents the opportunity for traders to enter the market according to the direction of the trend.
Limitations of ATR
There are two main limitations to using the average true range indicator. The first is that ATR is a subjective measure which means that it is open to interpretation. There is no single ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead, ATR readings should always be compared against earlier readings to get a feel of a trend’s strength or weakness.
Second, ATR also merely measures volatility and not the direction of an asset’s price. This can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points.