Average true range is an indicator that is used to measure and visualise the volatility of an asset and is commonly referred to as ATR. The market technician J. Welles Wilder Jr. first introduced us to ATR in his book “New Concepts in Technical Trading Systems”.
The ATR indicator uses all elements of an assets price as well as gaps that occur between sessions.
How to calculate the Average True Range
Many traders believe the average true range is defined as an average of the differences between high and low prices. Although this would be a worthwhile indicator it is not how the ATR is calculated.
ATR is calculated in two steps.
The first step is to define the true range for each trading session or interval. This could be daily, hourly, 15 minute, or any other interval.
The true range is the maximum value of the following three calculations
- High price minus low price
- Absolute value of (high price minus previous close price)
- Absolute value of (low price minus previous close price)
The absolute value simply means that a negative number is converted to a positive. This ensures that the true range is always a positive value.
Now that you have calculated the true range for each trading interval, it is simply a case of averaging over the required number of sessions required.
The following image shows the average true range indicator applied to the S&P 500 between December 2020 and January 20201.
This example shows the value of ATR increasing in periods of increased volatility and decreasing when volatility reduces.
The ATR indicator can be used for all asset types, including stocks, indexes, forex and commodities.
How to trade with the ATR
The average true range indicator measures volatility. There are a few uses for this indicator that a trader can utilise:
- to measure volatility for use within options trading
- to provide an approximate measure of a sessions likely trading range
- used as an input into setting stop loss levels
The volatility of an asset is a key component when calculating the corresponding option price. If a trader sees a rising ATR it may signal a trading opportunity. We have a dedicated page on options pricing.
The average true range indicator can be used by all types of trader to identify the likely trading range for the next session. This could be used by traders to help manage risk, or simply as a way of understanding possible price moves for an asset.
Most traders who have knowledge of the ATR indictor may have heard it being used to set stop loss levels. This is very beneficial as we are using price action data to determine our stop loss level.
When a trade is placed the initial stop loss level can be set at a specific multiple of the ATR. Using the example above we could set our initial stop loss at 45 points above/below the current market price of 3800. A move conservative approach would be to use a 2xATR level, meaning the initial stop loss would be at 90 points above/below the current market price.
For more information on how ATR can be used to exit potions please read our full article on entries and exits.
Another way to use ATR is with trailing stop losses. This type of stop loss is dynamic with the stop price changing as the market price changes. When a trade is placed with a trailing stop loss the initial stop loss level will be set at a multiple of the ATR. If the market price moves in your favour then the stop loss level automatically moves. Using ATR in this way means that a trader quantifies their stop loss level with market price action.
For more information on how the trailing stop loss works please read our full article on order types.
Summary
Average true range is a very useful technical analysis indicator that all traders will find useful. It provides the trader with a measure of volatility that can be used for varying purposes.
Whether you trade options and require knowledge of volatility, need help setting stop losses, or just want an insight into likely trading ranges, the ATR can be of great help.
Calculating ATR is very straight forward and only requires the High, Low and Close price for an asset. It comes as standard in most charting packages.