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Average True Range
Developed by J. Welles Wilder, the Average True Range (ATR) is an indicator
that measures volatility. As with most of his indicators, Wilder designed ATR
with commodities and daily prices in mind. Commodities are frequently more volatile
than stocks. They were are often subject to gaps and limit moves, which occur
when a commodity opens up or down its maximum allowed move for the session.
A volatility formula based only on the high-low range would fail to capture
volatility from gap or limit moves. Wilder created Average True Range to capture
this "missing" volatility. It is important to remember that ATR does
not provide an indication of price direction, just volatility.
Wilder features ATR in his 1978 book, New Concepts in Technical Trading Systems.
This book also includes the Parabolic SAR, RSI and the Directional Movement
Concept (ADX). Despite being developed before the computer age, Wilder's indicators
have stood the test of time and remain extremely popular.
True Range
Wilder started with a concept called True Range (TR), which is defined as
the greatest of the following:
Current High less the current Low
Current High less the previous Close
(absolute value)
Current Low less the previous Close (absolute value)
Absolute values are used to insure positive numbers. After all, Wilder was
interested in measuring the distance between two points, not the direction.
If the current high-low range is large, chances are it will be used as the True
Range. If the current high-low range is small, one of the other two methods
would likely be used to calculate the True Range. The last two possibilities
usually arise when the previous close is greater than the current high (signaling
a potential gap down or limit move) or the previous close is lower than the
current low (signaling a potential gap up or limit move). The high-low range
is used as the TR for day one because it is impossible to use the previous close
for the first day.
Example
of Average True Range in StockVision-PowerScan. ATR is not a directional indicator,
rather, it measures volatility. Notice how the ATR line runs high the more volatile
the stock becomes.
Conclusions
ATR is not a directional indicator, such as MACD or RSI. Instead, ATR is
a unique volatility indicator that reflects the degree of interest or disinterest
in a move. Strong moves, in either direction, are often accompanied by large
ranges, or large True Ranges. This is especially true at the beginning of a
move. Uninspiring moves can be accompanied by relatively narrow ranges. As such,
ATR can be used to validate the enthusiasm behind a move or breakout. A bullish
reversal with an increase in ATR would show strong buying pressure and reinforce
the reversal. A bearish support break with an increase in ATR would show strong
selling pressure and reinforce the support break.
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