The Average True Range (ATR) indicator formula is a technical analysis tool used by traders to measure market volatility. 

It helps to identify how much the price of an asset fluctuates over a specific period. ATR is important for understanding market behaviour and that helps traders decide when to enter or exit trades. 

What is ATR in Trading?

The Average True Range (ATR) is an indicator used in technical analysis that measures the volatility of an asset, such as a stock, currency pair, or commodity. 

It doesn’t tell you the direction in which the price is moving, instead, it tells you how much the price is moving over a specific period. 

The ATR gives you an idea of how volatile a market is and helps traders make decisions based on price fluctuations.

ATR was developed by J. Welles Wilder, a famous technical analyst, in his book “New Concepts in Technical Trading Systems.”

Wilder created ATR to help traders measure how much price movements were “normal” for an asset. 

This way, you could identify if a price move is significant or just part of the regular fluctuations in the market.

How is the ATR Formula Calculated?

To understand the ATR formula, we need to look at how it’s calculated. The ATR formula takes into account the following:

True Range (TR)

The True Range is the greatest of the following three values

• The difference between the current high and the current low.
• The difference between the previous close and the current high.
• The difference between the previous close and the current low.

Average True Range (ATR)

Once the True Range for each period is calculated, the ATR is the average of these values over a specific number of periods.

The ATR is calculated by averaging the True Range over a set number of periods (often 14 periods are used as the standard).

ATR = Sum of True Range over n periods​ / n

Where:

• n is the number of periods you want to analyze (usually 14).
• The sum of the True Range is added up over the chosen periods and then divided by the number of periods.

Let’s explain with an example.

Example of ATR Calculation

Suppose you’re looking at the price movement of a stock for 5 days. Below is a simplified breakdown of the data:

• Day 1: True Range = 50 (high) – 45 (low) = 5
• Day 2: True Range = 52 (high) – 46 (low) = 6
• Day 3: True Range = 55 (high) – 50 (low) = 5
• Day 4: True Range = 55 (previous close) – 53 (high) = 7
• Day 5: True Range = 56 (high) – 51 (low) = 6

Now, to find the ATR, we add up the True Ranges for all 5 days and divide by 5 (the number of days):

ATR =  5+6+5+7+6 / 5 =  29 / 5  ​= 5.8

So, the ATR for these 5 days is 5.8.

How to Use the ATR Indicator in Trading

The ATR can be used in various ways to help traders make better decisions in the market. 

Below is how you can apply it:

1. Identify Market Volatility

A high ATR indicates that the market is more volatile, and price swings are bigger. A low ATR indicates that the market is less volatile, and price movements are smaller.

• High ATR: If the ATR is high, it suggests that large price movements are happening, which can be an opportunity for traders who want to capitalize on big price swings. However, it also indicates higher risk.
• Low ATR: A low ATR means that the market is quieter with smaller price movements, often leading to less profit potential but also lower risk.

2. Setting Stop-Losses

Traders often use the ATR to determine how far to set their stop-loss orders. For example, if the ATR is 5 points, and you want to avoid getting stopped out by normal market fluctuations, you may set your stop-loss at 1.5 or 2 times the ATR away from your entry price.

3. Position Sizing

ATR can also help determine how much capital to risk on a trade. Traders can use ATR to adjust their position size based on volatility. 

If the ATR is high, they may risk a smaller position to protect themselves from big price swings.

4. Trend Confirmation

A rising ATR indicates that volatility is increasing, which can confirm a strong trending market. Conversely, a falling ATR suggests that volatility is decreasing, which may indicate the trend is losing strength.

Pros of Using ATR

1. Simple to Use

ATR is easy to calculate and understand, making it accessible for traders of all levels, from beginners to professionals.

2. Helps Manage Risk

ATR helps traders set appropriate stop-loss levels based on volatility, reducing the chance of being stopped out by normal price fluctuations.

3. Can Be Used Across All Markets

ATR works well for all types of markets, including stocks, forex, commodities, and cryptocurrencies.

4. Helps in Position Sizing

ATR can assist traders in determining how much capital to risk in a trade based on the market’s volatility.

Cons of Using ATR

1. Does Not Indicate Price Direction

ATR only measures volatility and does not tell traders which direction the market is moving. Traders still need other indicators or analyses to understand price direction.

2. Lagging Indicator

Since ATR is based on historical price data, it can sometimes lag behind the market. This means it reacts to past price movements and may not predict future volatility.

3. Can Be Misleading in Ranging Markets

ATR works best in trending markets. In a ranging (sideways) market, the ATR may remain low even if there are small price swings that traders could profit from.

4. Over-Reliance Can Be Harmful

ATR should not be used in isolation. Over-reliance on ATR without considering other technical indicators can lead to poor trading decisions.

How to Combine ATR with Other Indicators

To get the most out of ATR, it is best to combine it with other technical indicators. For instance:

1. Moving Averages

Combining ATR with moving averages can help confirm whether a trend is strong. If both the moving average and ATR are rising, it signals a strong bullish trend.

2. RSI (Relative Strength Index)

When combined with ATR, the RSI can help indicate whether the asset is overbought or oversold, adding context to the volatility reading provided by ATR.

3. Bollinger Bands

ATR can also be used with Bollinger Bands to measure price volatility. When the price moves outside of the Bollinger Bands, it often suggests that a significant price move is coming, especially if accompanied by a rising ATR.

Frequently Asked Questions

1. What is the best time frame to use ATR?

ATR can be used on any time frame, but it is commonly applied to daily, weekly, or 14-day charts. Shorter time frames can provide more frequent signals, while longer time frames can give more reliable data.

2. Can ATR be used for day trading? 

Yes, ATR can be used for day trading, but traders should adjust their stop-loss and take-profit levels based on the volatility observed in shorter time frames.

3. Does ATR predict price movement? 

No, ATR does not predict the direction of price movement; it only measures volatility. You will need to use other indicators or analysis techniques to predict price direction.

4. Can ATR be used in all markets? 

Yes, ATR works in all markets, including stocks, forex, commodities, and cryptocurrencies. It’s a versatile tool for measuring volatility.

Conclusion

The Average True Range (ATR) is a powerful tool for measuring market volatility and understanding how much the price of an asset is likely to move over a given period. 

However, it is essential to combine ATR with other indicators for a complete picture of market conditions.

Remember, ATR doesn’t predict market direction but helps you understand the potential for price movements, which will help you make informed trading decisions.