What is an Average True Range (ATR)?
Average True Range (ATR) is the moving average of the true range values. It is the indicator of market volatility. ATR was developed by J. Welles Wilder and introduced in his book ‘New Concepts in Technical Trading Systems in 1978’; Commodities were frequently more volatile than stocks in 1978. These commodities were subjected to gaps and limit moves. At that time Wilder though to design ATR with commodities and daily prices. So Wilder sought to account for gaps, limit moves, and small high-low ranges in his calculations in order to accurately reflect the volatility associated with commodities.
The ATR was developed for commodities but it can also be used for stocks and indexes. Wilder then started the concept of True Range (TR) that defines the current high less the current low, the absolute value of the current high- less the previous close, and the absolute value of the current low less the previous close. If the current high-low range is large, then it will be used as the True Range. It is likely that one of the other two methods would be used to calculate the True Range if the current high-low range is small. When the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move), then the last two possibilities usually will arise and absolute values were applied to differences in order to have positive numbers.
How to calculate the ATR? In today’s trading, the range is imply high-low, which means that true range extends it to yesterday's closing price if it was outside of today's range:
true range = max(high, close prev) − min(low, close prev)
Take note: the n-day exponential moving average of the true range values is the average true range. The 14- period smoothing is what Wilder recommends. Traders will continue to bid up or sell down a stock through the course of the day if there is a large or increasing range. On the other hand, decreasing range suggests waning interest.
After a sheer fall in prices occasioned by panic selling, Average True Range can often reach a high value at the bottom of the market. On the other hand, low values of the indicator are typical for the periods of sideways movement of long duration which happen at the top of the market and during consolidation. Therefore, True Range can be interpreted according to the same principles as other volatility indicators. In summary, Average True Range (ATR) principle is that the higher the value of the indicator, the higher the probability of a trend change; the lower the indicator’s value, the weaker the trend’s movement is.