The ATR is an attempt at finding out about trader sentiment by comparing price ranges over a period of time. To do this in an easily understood and observed manner, the range values are presented in the form of an exponential moving average.
Note: Past performance is not indicative of future results.
As we see, the ATR looks more like an oscillator than a moving average. This because of the fact that although prices do not have bounds (they can move as high or low as the market can take them), the actual trading range is in fact confined to practical limits during even the most heated action in the market. By making use of this knowledge J. Welles Wilder was able to create an exceptionally simple, yet powerful and tradeable indicator.
Calculation of the ATR
The average true range indicator is in some ways similar to the commodity channel index discussed in this site. Here also, we compare price ranges with previous values to establish overbought oversold levels. But unlike the CCI, the ATR itself is a moving average: namely, it is the exponential average of a concept called the “true range” over a trader-determined period. Let’s examine how it is calculated in greater detail.
Let’s first define a few concepts used in the determination of the true range:
The range is the value (H – L) where H is the high, while l is the low of the price over the period.
The true range is the extension of this concept to the period prior to the one in consideration. It is defined as Max(high, close) – Min (low, open) of the previous period, if the price action extended beyond today’s range in that timeframe. In plainer terms, the true range is the largest distance between the high or close, and low or open of a time period. It is an attempt to discover the greatest extent that the price action covered, thus establishing how agitated traders were.
The Average True Range indicator is then computed by taking the exponential moving average of the true ranges of a predefined period. The exponential moving average is sensitive to the latest movements in the price, and it is thus used as a gauge of trader enthusiasm in the market.
Trading with ATR
There are two ways of using the ATR. One is looking for divergence/convergence patterns between the price action and the indicator values. If the range is contracting even as the market is breaking new records, we would consider the possibility that traders are losing confidence in the momentum of the market. Otherwise, successive highs would result in greater ranges as more and more traders are excited about the price action. Another way of utilizing this indicator is looking for trends in the daily ranges, and entering or exiting positions in anticipation of breakouts. If the EMA is showing pattern of increasing ranges while the price action itself is muted, there is signal that a consolidation formation will culminate in a breakout one way or the other.
As with the CCI, and the Williams Oscillators, the ATR is a volatile indicator. If you plan to use it in your trade decisions, it is a good idea to complement your trading strategy with strong risk controls so that the whipsaws that materialize, like those observed in the chart, do not lead to unacceptably high losses.
Finally, it is very important to understand that the ATR does not say much about price direction, or trend duration. It measures the volatility of the price action, and is useful for analyzing extremes of positioning, both in trends, and range patterns. For analyzing direction and duration, we should use other indicators derived for this purpose.
ATR is not one of the most popular indicators out there, but it is regarded as a part of the standard toolbox of any trader, beginner, or professional. It comes as a part of the Easy-Forex trading software, the MetaTrader platform, as well the trading packages of MGForex, or ForexClub. Some minimalist designs may not include it, so it is a good idea to check before you make a decision about your account.
The ATR indicator is a powerful tool for volatility based strategies. Although prone to generating whipsaws, its role as a volatility indicator means that you can determine the type of market that you wish to trade with the ATR, while deriving actual signals and entering trades on the basis of other secondary strategies. Most of us have a good idea on how important volatility is in determining the profit potential, and suitability of a particular market environment for our trading decisions. The ATR, along with the Bollinger Bands, is an exceptional way of measuring this aspect of the market, and offers great potential to those who seek to use it.