Average true range (ATR)

The average true range indicator was developed by technical analyst J. Welles Wilder as a volatility indicator for the commodities market. In addition, it can applied to any financial market that shows volatility, in particular, stocks, currency pairs and indices.

The average true range is plotted on a trading chart as a single moving average line, which is calculated by the true ranges. This is usually on a candlestick chart, where volatility and price gaps are easy to spot. These types of charts are useful as traders can use the charts to identify entry and exit points for their positions.

The general rule is that a high ATR value indicates a higher level of volatility, whereas a low ATR value indicates a lower level of market volatility. Please note that the average true range does not represent or suggest market trends, only volatility and price gaps. As always, technical indicators tend to work well in conjunction with others; in this case, an indicator that could be used alongside the average true range to measure trend strength is the average directional index (ADX), also created by Wilder. This will ensure that all aspects of price action, trend and market volatility are covered for a comprehensive trading strategy.

The average true range is a classic component of technical analysis, and it measures market volatility in a similar way to the relative strength index (RSI) and exponential moving average (EMA). Technical analysis is the study of price action and ignores all other aspects of fundamental analysis, such as external factors that can affect an asset’s price. By studying price charts continuously, short-term traders can assess where to plot profit targets, as well as execution types and stop-loss orders. The ATR can be used to generate buy and sell signals, depending on how volatile the market is, so a trader can decide whether to go long (buy signal) or short (sell signal) on a position.

Before figuring out an average true range calculation, you need to calculate a series of true ranges first, which are based on historical price data. The true range of a given period is the greatest sum of the following:

Average true range = (previous ATR x (n-1) + TR) / n

Where:

n = number of periods, so in most cases, this will be 14

TR = true range

The average true range indicator was originally created for use within the commodities market, but has since expanded to a wide range of markets, which include forex trading and shares. The indicator can also be used for long-term and short-term trading strategies, such as position trading, day trading and scalping.

When making trading decisions based on the average true range, it is important to consider your exit strategy. Many traders use stop loss orders, in particular a trailing stop, as a method to exit a trade if the markets move in an unfavourable direction to their position. However, if the market is moving in your favour, you can modify the exit point, where the trailing stop will follow behind the price to lock in profits.

For example, when analysing a price chart, traders often use the ATR to determine where to place a trailing stop loss. You can multiply the current ATR reading by two and place the stop loss at this level. If you are going long, you can place the stop loss below the entry price, and if you are going short, you can place the stop loss above the entry price. If the price is moving in the direction of potential profits, the stop loss will continue moving up or down until you close the position, once the trailing stop loss level is reached. This is known as a ‘chandelier exit’ strategy.

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