Introduction To Average True Range (atr)

Introduction

The Average True Range (ATR) is an indicator that was developed by J. Welles Wilder, Jr. who introduced it along with a few other indicators (Parabolic SAR, RSI and the Directional Movement Concept) in his book, “New Concepts in Technical Trading Systems” in 1978.

The ATR was originally designed by Wilder to appropriately measure the volatility of Commodities, an instrument that typically has gaps and limit moves that occur when a commodity opens up or down its maximum allowed move for the session.

Today, the ATR may be one of the oldest indicators that exist but it is far from being obsolete. What’s very interesting about this indicator is its universal and adaptive nature. That’s why it remains applicable and popular among good trading systems and is used with a wide variety of instruments.

Many trading systems use the ATR as an essential tool for measuring the volatility of the market. The Average True Range reveals the volatility in a particular instrument but it does not indicate the price direction.

Any trader who is keen on designing an excellent trading system should be familiar with the Average True Range and the many ways it can be used to improve the performance of any trading system.

The ATR has numerous functions and it’s generally applicable in finding trade setups, entry points, stop loss levels and take profit levels with reasonable money management technique.


Definition of Terms & Related Concepts

Before we proceed, let’s define a few terms that we will be using frequently as we talk about the Average True Range...

Average True Range (ATR) is an indicator that measures volatility. It is a “moving” average of the true range for a specific given period.

Volatility is defined in terms of market action. An active market is said to be volatile while an inactive market is considered non-volatile. Volatility is directly proportional to the range, so if range increases, it also increases. If the range decreases, so does the volatility of the instrument.

Range is the distance that the price moves per increment of time. It is the distance from the highest price to the lowest price of the day, in other words, equivalent to the height of 1 bar or candlestick. It is calculated by taking the difference between the high point and the low point.

However, if the current candle is a Doji where the price does not move at all, the real price range is actually the distance from the previous close to the open price of the Dogi (current candle). Also, if the close of the previous candle is not within the current candle, the range begins from the close of the previous candle.

It follows that the True Range (TR) is the maximum range that the price has moved either during the current candle or from the previous close to the highest point reached during the candle. True Range is defined as the greatest distance of the following:

A. Current High to the Current Low
B. Previous Close to the Current High
C. Previous Close to the Current Low

Absolute values will be used for the calculations to get the distance between the two points. This is because the aim is to get the distance and not the direction. The first range will be used for the calculation of the initial True Range. We will talk more about that in another section.

According to Wilder, you must consider the value of the range for a number of periods in order for it to be a useful tool to measure volatility. This is why an average of the true range over a number of periods must be obtained. A sufficient number of periods must be used to provide sufficient sample size to obtain an accurate indication of an instrument’s price movement. He considers 14 bars to be the best indicator of volatility and uses it for his Volatility system. You will know more about this system as we go along.