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Technical Analysis, Studies, Indicators:
Average True Range (ATR)
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The Average True Range (ATR) indicator
has been developed by J. Welles Wilder as a measurement of a security's
volatility in 1978. The ATR indicator does not reflect the price
direction and is not used to predict price, yet this indicator is widely
used in technical analysis to measure the degree of price movement or
price volatility.
The idea behind ATR indicator is to take into account overnight trading
when a security price could make a jump at the market open. In some
cases a stock or commodity could have gap up or down at the market open,
and then move flat the rest of the session. Since the difference between
High and Low in this case is not big, the candle of this bar is going
to be small which will not reflect the actual jump in price from the
precious day close. In order to more precisely reflect the volatility of
an analyzed security Wilder offered using previous bar close price to
capture gaps which would not be counted by a formula based on the
high-low price range only.
The principles behind ATR calculations are simple and could be split in
two steps:
Step #1: Define True Range (TR).
Step #2: Apply Moving average to defined TR.
The True Range is defined as the highest number from the following:
- The difference between the current bar
High and the current bar Low.
- The absolute value of the difference
between current bar High and the previous bar Close.
- The absolute value of the difference
between current bar Low and the previous bar Close.
In majority of the cases, the high-low range
is the largest and is used in the TR and ATR calculations. Yet, for volatile
securities (that have tendency to start trading with gap up or down at the market
open) the previous day close would be used in the TR and ATR calculations. The
TR value is always positive and absolute value should be used in a situation
when previous bar close is higher than the current bar High or lower than the
current bar low.
After TR is calculated , the moving average applied to it. As an example, ATR(11)
stays for 11-bar
moving average of TR. Some technical analysts use simplified method of
calculating the Moving Average applied to TR. For instance, to define the
ATR(11) the previous ATR(11) bar is multiplied by 10, then the current bar TR
value is added and the result is divided by 11.
Keep in mind that low priced low price stocks have lower ATR than high price
stocks ( a $5 stock has lower ATR than a $500 stock). Furthermore, it would be
wrong to compare ATR of stocks from the different price range.
Chart 1:
Nasdaq 100 index - Average True Range (ATR).
The ATR indicator could be very useful in
trading systems to define stock market periods of high volatility. From the chart above you may
see that since August 2007 the Nasdaq 100 index has been 2-3 times more
volatile. It means that from that month the Nasdaq 100 price changes its
direction 2-3 time faster then before. As a result, technical indicators
setting used in the period prior August 2007 may fail to generate signals
after that month. The old indicators setting may simply open and close a trade
when it is already too late.
As you may see the ATR helps identify high volatile period. In August 2007 by
having ATR data, proficient in technical analysis trader would adjust the
indicators to be more sensitive and faster react on the price changes.
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