Simply put, this indicator measures volatility. Created by a man named Wilder, it was designed with daily prices and commodities as reference points. Commodities differ from stock mainly in that commodities are with more gaps, longer trading hours and more often circuit filter hits than large cap stocks.
Many traders use this indicator to gauge stock volatility as well. Wilder also developed the Directional movement concept, Parabolic SAR and the RSI which are some of the most used indicators today.
It measures degree of price volatility only, so you cannot use this to gauge market direction.
The range of a day (or any candle) is simply the high minus the low, this was the extent to which price was able to traverse during the day.
The indicator makes an exception to this calculation on gap days or inside days, so in summary:
The true range is the largest of the:
• High minus the low (most recent)
• Recent high minus the previous close
• Recent low minus the previous close
The average true range is a moving average (generally 14-days) of the true ranges.
If you remember the election results period in May 2014, the stock market exhibited a great amount of movement than it was previously bouncing in the range of. A single day fluctuation of 2,000 points on the Sensex(1,000 points up then down) was seen on the election declaration day of 16th May 2014.
This is a chart of Nifty of the same time, as you can see the ATR has shot up in showcase of the market volatility.
Current ATR = [(Prior ATR x 13) + Current TR] / 14
– Multiply the previous 14-day ATR by 13.
– Add the most recent day’s TR value.
– Divide the total by 14
The ATR is not a directional indicator like the RSI, ADX, Stochastic or MACD, it is a unique indicator that measures volatility, or the interest or dis-interest in a particular move. It can be used to reinforce the belief in a move, if there a surge in the ATR after a bullish reversal then you might conclude there is power in this move up. The same applies for bearish reversals where it comes forward as a reinforcer not as a leading indicator.
Other essential uses of the ATR are to help us increase or decrease our stop loss levels. Think about it, if the market is more volatile then it is more likely to hit your stop loss isn’t it? It would probably be a better idea to increase your stop loss space and your trade target too during highly volatile times.
The same is true for contraction of ATR, it is probably better to gun for smaller profit targets and have smaller stops in your intraday trades when ATR is low.
You should do your own research but on the Nifty Futures a level of 22 (on the ATR15) or above indicates an impending volatile scenario. Think about adjusting your stops according to volatility contraction and expansion!