The Average True Range Indicator (ATR Indicator) was developed by Welles Wilder as an instrument for determining market volatility. The indicator tries to appreciate the interest of the market in the price movement, since sudden movements and changes in the trend are usually accompanied by wide ranges . So, ATR can help day traders confirm when they might want to initiate a trade, and it can be used to determine the placement of a stop-loss order.
In the world of “trading”, Volatility generates opportunities that is why it is interesting to measure it and one of the best ways to do it is using the ATR Indicator. So, Volatility is the amplitude or range of movement that quotes make in a certain time, in trading where we seek to carry out short-term operations, as a general rule, we do not feel more comfortable when there is volatility, because more volatility also means greater travels in the same time and therefore greater profit potential, but must be accompanied by proper risk management. Many trading systems perform at their best, when Volatility is highest . Volatility is Cyclical, which means that periods of low volatility will be followed by periods of high volatility or the opposite. So, being aware of this is useful to learn to wait for the best periods to operate our trading systems but also to adapt the management of the risk to current volatility in the market .
The ATR is plotted in a similar way to an oscillator below the price and it looks like this (See Figure 1). The Volatility should be analyzed as something cyclical but not static, the ATR is useful for any market and timeframe. Its calculation method is very simple, the true range is calculated taking the highest of these three values, the last maximum minus the last minimum, the last maximum minus the previous close and the last minimum minus the previous close, then a Moving Average is calculated generally of 14 periods and its value is reflected in a graph below the price graph as it happens with the MM, the higher the calculation period, the smoother the behavior of the ATR will be and vice versa (See Figure 1). As a general rule, 14 works well enough in any temporality and it is interesting to modify it depending on the temporal proportions that you work with. If you don't know which parameter to put 14 will be enough.
Wilder originally developed the ATR for commodities, although the indicator can also be used for stocks and índices . Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR.
The first step in calculating ATR is to find a series of true range values for a security. The price range of an asset for a given trading day is simply its high minus its low. Meanwhile, the true range is more encompassing and is defined as:
The ATR is commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the "chandelier exit" and was developed by Chuck LeBeau. The chandelier exit places a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR .
The data that the ATR gives us can therefore interpret as the average path that the price has made in each average period or what is the same as how much we should expect on average that the price travels in a single candle or bar. We know what route each candle has been doing on average, we have a much clearer dimension of how close or far our stop loss or profit target can be, we will also have an objective and measurable data of whether the market is moving a lot or Little in more advanced analysis will help us to measure the state of volatility cycles, since most cycles occur with some regularity, so defining the regularity of these volatility cycles helps us to predict when we can expect it to increase or decrease. Look at this example (See Figure 2) an analysis of volatility cycles and the regularity with which the cycles are repeated .
The ATR is also useful to decide the placement of stop losses in certain trading systems, if we know on average how much the price has been traveling per period we could take a multiple of the value of the ATR as a minimum reference for our stop losses based on the typical duration of our operations, the same could be done with the profit taking zones, whether partial or total, if we reference it at a multiple of the ATR we will have a clearer perception of how likely it is that it has been reached in a certain time.
The ATR measures the current Volatility of the market, a data that can be very useful as confirmation in the breaking of levels in risk management and monetary management, but also in the analysis of volatility cycles, it is an extremely intuitive data of interpreting that makes it easy to apply, although it is graphical as an oscillator, its interpretation is not the same, although it also helps us measure the market momentum through its volatility and therefore what average route we can expect per unit of time.
There are two main limitations to using the ATR indicator. The first is that ATR is a subjective measure, meaning that it is open to interpretation. There is no single ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead, ATR readings should always be compared against earlier readings to get a feel of a trend's strength or weakness. Second, ATR only measures volatility and not the direction of an asset's price. This can sometimes result in mixed signals, particularly when markets are experiencing pivots or when trends are at turning points. For instance, a sudden increase in the ATR following a large move counter to the prevailing trend may lead some traders to think the ATR is confirming the old trend; however, this may not actually be the case .