What Is ATR and Why Use It in Trading
Average True Range (ATR) is a technical indicator first introduced by J. Welles Wilder Jr. in his 1978 book New Concepts in Technical Trading Systems – the same author in the same book also introduced other popular indicators such as the Relative Strength Index (RSI), Average Directional Index (ADX) or Parabolic SAR (PSAR). At present, ATR is one of the best known technical indicators and, in my view, one of the most useful.
What Exactly Is ATR?
Average True Range, as its name suggests, is the average of “true range”, which is a slightly more sophisticated version of range.
While range is simply the difference between high and low of a trading day or bar, true range is the greatest of these three:
- high minus low (= range)
- high minus previous close
- previous close minus low
As you can see, true range is often exactly the same as range. The cases when it is greater than range (it can’t be smaller) are when there is a gap between days or bars – when previous close is outside the current bar’s range (higher than high or lower than low). For more detailed explanation of true range with examples, see True Range and How It Differs from Range.
Once you have true range, ATR is calculated as average of true range over a number of days or bars – this number is called the ATR period. There are three common methods to calculate this average (simple, exponential, and the original Wilder’s smoothing method).
What Is ATR Good For?
Like range, and unlike most other technical indicators, Average True Range doesn’t tell you anything about direction.
For instance, moving averages can tell you whether the trend has been up or down and how strong. Other indicators, such as %R or the already mentioned RSI can help you identify overbought and oversold conditions in the market. All these tools are about up or down, bullish or bearish, high or low, buy or sell.
On the contrary, ATR does not contain any information about price direction, at least not on its own.
Instead, it measures another very useful characteristic of the market – volatility.
ATR as Volatility Measure
You may be already familiar with volatility measures such as historical volatility (standard deviation of returns) or the VIX and similar volatility indices (which measure implied volatility of options). The meaning and use of Average True Range is often closer to these tools than to the likes of moving averages or RSI.
In a way, you can see ATR as a combination of (average) range and historical volatility.
Both range and historical volatility are very useful volatility measures, but each lacks something.
Historical volatility, being calculated as standard deviation of returns, works with changes in closing price – but closing price alone. It can’t capture any information about the highs and lows. It tells you how volatile the market has been from day to day, or period to period, but it can’t tell you anything about volatility within the individual days or periods.
On the contrary, range (high minus low) or average range (the average of range over a number of recent days or periods) are good for measuring intraday or intrabar volatility (the thing that historical volatility can’t do), but they don’t tell you anything about the changes between days or periods, because closing prices don’t enter the calculation of range in any way.
The power of ATR is that it measures volatility including both the close-to-close volatility and the high-low range. It combines the strengths of historical volatility and range.
ATR Trading Strategies and Uses
ATR can be used for many different things – it’s hard to think of another technical indicator with such a wide scale of possible uses.
For instance, you can use ATR for deciding what to trade (stock screening), when to trade (strategy filtering), or position sizing. As a measure of volatility, which goes hand in hand with risk, ATR is a natural tool for setting stop losses, profit targets or position exits in general.
Moreover, although we have said ATR doesn’t tell you anything about price direction by itself, it can actually be used for trade entries in a wide range of strategies, including trend following, channel breakouts or range-bound mean reverting strategies.
Of course, each of these purposes requires the interpretation and use of ATR in a slightly different way, sometimes with small adjustments (like ATR bands) or in combination with other tools (like moving averages).