Published On: Sat, Aug 15th, 2020

What is Average True Range (ATR) – Trading Stock Indicator

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There are a lot of different technical indicators for the use of technical analysis available in the market. Nowadays, technical analysis tools are used frequently by traders and investors to have a better idea and understanding of the particular asset class they are looking to invest in.

It must be kept in mind that these technical indicators, despite being successful in the past, do require sufficient caution and due care during usage.

Today, we will be talking about a very popular, yet classic, technical analysis tool or indicator called Average True Range (ATR).

In order to keep increasing your understanding of various technical indicators and of stock investing, you are more than welcome to access our finance section.

Also read: Stocks vs. Bonds

What is ATR?

The Average True Range, abbreviated as ATR, is a popular technical analysis indicator used on wall street to determine the volatility of the market and, more specifically, the particular asset class by considering the entire range of prices for a specific period. Market technician J. Welles Wilder Jr first introduced this technical indicator through his book “New Concepts in Technical Trading Systems.”

The average true range trading indicator is considered as the highest of the following: Absolute value of the current low deducted by the previous close; the current high less the previous close high’s absolute value; the previous low’slow’s absolute value.

The greater of all of these is considered a true range, and in order to come at the average true range, you just have to calculate the moving average of the true range for a particular period, usually 14 days.

The mathematical formula for ATR

You must already be aware of the concept of the price range in stock trading. It is very easy to calculate, all you need to do is to deduct day’s low from the day’s high, and that’s it. True range, however, is a more comprehensive and detailed indicator.

Although we have explained the basic formula for practically calculating the true range for trading, that can be a really long process done like that, so, it is best to use mathematical formula it is defined as:

TR = Max[(H − L), Abs(H − CP​), Abs(L − CP​)]
ATR: (1/n​)(i=1)∑(n)​TRi

Where:
TR = True Range
ATR: Average True Range

As mentioned above, traders commonly use a 14-day period to calculate ATR, but you are more than welcome to use even a shorter period. Using such a period that is shorter than the average, the trading signals are likely to be more. Similarly, if longer periods are used for calculating a stock ATR, less trading signals are generated.

What does ATR indicate?

This technical indicator was originally developed specifically for use in the commodity market. However, stock traders have also used it to calculate the daily volatility of the market and that particular stock they are interested in. Day traders can use ATR with huge success while trading stocks if used wisely.

It can be assessed in determining the right moment for entering and exiting the market. Also, unlike many other technical indicators, it does not indicate specific price direction and is used to determine merely market volatility.

A stock that is highly volatile will naturally have a higher ATR, and in the same fashion, a lesser volatile stock would have a lower ATR. Most traders use ATR as an exit method, which is pretty universal as it can be used without even considering the entry point.

The most popular technique in this regard is known as the ”chandelier exit.” As per this technique, a trailing stop is placed right under the highest high of the stock since you purchase it. In technical terms, the exact difference between the stop level and the highest high is termed in some multiple times of the ATR.

A derivatives trader or investor can also use the ATR indicator to size his trade in the derivative markets. It is considered a very useful tool to position sizing in accordance with an individual trader’s capacity to take risks along with specific market volatility underplay.

Also read: What Is The Golden Cross: Technical Stock Indicator

Limitations of using ATR

As mentioned above, there are a lot of important benefits associated with the usage of ATR in stock trading. However, just like every other technical indicator, ATR is ”lagging” as well. There are two primary limitations of using the ATR.

The first is that the average true range measure is a subjective one, which means that it is open to interpretation. You will not find a single ATR value which will Predict with accuracy if a trend is about to reverse or not. On the contrary, the readings of ATR must always be compared against readings done earlier in order to get some idea about a trend’s weakness or strength.

The second most considerable limitation of using ATR during stock trading is that it is only known for measuring market volatility and not the actual direction of the asset’s price.

As it may seem at this particular point, it can be a real downside of using ATR as mixed signals can sometimes be interpreted, specifically when markets are experiencing turning points or pivots. For instance, rapid enhancement in the ATR after a massive move against the prevailing trend would make some stock traders feel that this trend is a representation of an old trend confirmed by the ATR, and it certainly is not the case.

Conclusion

Despite being an old, trusted, and largely useful technical indicator, ATR must be used with caution, as there are certain and considerable limitations attached to the usage of ATR during trading stocks. Earlier, it was only used for derivatives, but recently the importance and relevance of ATR in the stock market have been realized.

Just like most of the other technical indicators, you must not follow the ATR blindly. You must only take into consideration a trend suggested by the ATR if other multiple technical indicators also recommend that particular trend because otherwise, you could end up in a pit.

For more such articles on different tools of Technical Analysis and fundamentals of stock market investing, please feel free to visit our finance section.

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