Average True Range

Average True Range or ATR was developed by J. Welles Wilder in 1978 to measure the degree of price movement or volatility over a given period and does not provide price trend.

Wilder intended to use ATR (on commodities and can also be used for stocks and indices) so as to account for gaps, limit moves (e.g. The daily price limits for wheat is 30 cents) and small high and low ranges in order to detect the volatility, which represents market noises. High values denote that prices have drastic change during the day; lower values indicate that prices are moving relatively constant. In a nutshell, the higher the ATR is the higher the volatility and the lower the ATR will be, the lower the volatility.

Many traders are using this indicator for setting their stop losses. For example, a speculator has a long position and wants to place a stop loss order. He will use the current 14-day ATR times 0.5 (one has to do some back-testing to find out the desired value) and subtracted the value from his entry price. It means the market would have to surpass the average daily range before he will incur losses.

To compute the ATR, Wilder recommended a 14-period smoothing as a default value. The first step is to determine the daily true range or TR by getting the largest difference of the following: (1) the current high less the current low (2) the absolute value of current high less the previous close (3) the absolute of current low less the previous close. The first 14-day ATR is the average of the daily TR in the past 14 days. The second and subsequent 14-day ATR is calculated by multiplying the previous 14-day ATR by 13. Add the product by the most recent TR value and divide it by 14.

Example

S&P 500 Index – Pit

The S&P 500 Index – Pit chart shows extreme levels of the 14-day ATR. High levels of ATR denote high volatility which usually results from a sharp advance or decline. Low levels of ATR indicate quiet trading which forms small trading ranges. It might be the beginning of continuation or reversal move.

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