Average True Range (ATR)

ATR is a kind of technical analysis indicator that helps a trader or investor assess market volatility and make informed decisions. With the help of ATR, traders tend to get a better understanding of the price movement's intensity over a given period.

As a trader you could be keeping a watch on various technical analysis indicators to assess the market volatility. When it comes to protecting your hard-earned money in the risky world of stock trading, a few tools may become your saviour. 

Market participants resort to various tools or indicators that help them make informed decisions when it comes to investing in an asset class. Average True Range (ATR) is one such popular indicator that helps traders assess risks and know about good stop-loss levels.

Let’s discuss the various intricacies of ATR and know its definition, calculation and practical applications.

What is Average True Range (ATR)

ATR is a kind of technical analysis indicator that gauges market volatility. ATR theory was first developed by J. Welles Wilder, the American real estate developer known for introducing the Relative Strength Index (RSI) and the Average Directional Index (ADX). 

With the help of ATR, traders tend to get a better understanding of the price movement's intensity over a given period.

ATR Calculation
As far as ATR calculation is concerned, it involves a multi-level process. The main goal is to get to a True Range (TR) for each period and then find the average of these True Ranges. The True Range is determined by choosing the highest of the following three values:

• Current High minus Current Low
• Absolute Value of the Current High minus Previous Close
• Absolute Value of the Current Low minus Previous Close

Average True Range (ATR) Formula

ATR = (Previous ATR * (n – 1) + TR)/n

Where, n = number of periods or bars and TR = True Range.

ATR is derived from a 14-day simple moving average of a series of TR indicators. 

Talking about the trading view, one can see the ATR indicator showing as a line underneath the chart. Even though it can be calculated on any timeframe, ATR is generally discussed and interpreted in terms of the daily timeframe – which means that ATR can tell a trader how much a stock will go up or come down in a particular trading day.

ATR Value Interpretation

As a trader, understanding ATR values is important for you. Because, a higher ATR score suggests heightened volatility, which means larger price movements. Similarly, a lower ATR score means less volatility and comparatively smaller price fluctuations. By analysing ATR values, you can tailor strategies to suit the prevailing market conditions.
Practical applications of ATR

Fixing stop-loss levels

One of the key ATR applications is in marking stop-loss levels. Traders use a multiple of the ATR value to set a buffer that accommodates normal price fluctuations. With this dynamic approach, you can adjust the stop-loss levels while keeping in mind the market's volatility.

Position sizing

ATR also helps in determining the exact position size for a trade. By including the volatility measure, traders can easily know their position sizes and also be aware of the risks, thus avoiding overexposure during periods of high volatility.

ATR's limitations

Even though the ATR is beneficial and a key tool for traders, it has some limitations. Traders do not get directional information from ATR, and it only focuses on volatility. Furthermore, ATR might not be as useful in highly trending markets, especially when volatility is constant.

To sum up

Overall, the Average True Range (ATR) as an indicator is a boon for traders, helping them gauge market volatility and make key investment decisions accordingly. ATR's versatility as far as its applications are concerned, spanning from fixing stop-loss levels to gauging trend strength, sets it apart from many other tools. It is particularly helpful for those who look for a complete understanding of price movements. Traders who completely understand and interpret ATR values find themselves ahead in the game as they can easily navigate the volatility with more confidence.