Average true range (ATR)
In an earlier article about the ADX indicator, I promised to post an article about the Average True Range (ATR). I will discuss the ATR indicator in the article you are reading right now. I will write about the signals the ATR sends and the calculation of the ATR. When using a technical analysis method, I personally always want to know how to interpret the signals and how to avoid misusing the technical analysis method. This will also be part of this article.
As you could have read in the article about the ADX indicator, the ATR indicator is part of the calculation of the ADX. The reason why I have first discussed the ADX indicator, is that the ADX indicator sends easier to understand signals. Besides that, the ATR is not a leading indicator, and thus does not send buy or sell signals.
Why use ATR?
So the ATR indicator does not sends buy or sell signals. You now might think that the ATR is an useless indicator. But that is not what the ATR is. With the ATR, the volatility of the market can be measured. The price volatility is an important factor for investors. The price volatility can be used for deciding where to set your stop-loss or option trading.
When price volatility is high, you should not use tight stops. The chance that such a stop will be breached is high and your stocks will be sold (and after that, the stock will rise and you lose money). On the other hand, when the volatility is low and you do not want to run the risk of a sudden decline of the stockprice, you can set an tight stop.
Besides setting stops, the ATR can also be used for option trading. One important factor of option trading is price volatility. When the volatility is high, the option prices will also be higher. When the volatility is low, the volatility premium on options should also be low.
Signals send by the ATR
Now you know where the ATR can be used for, you would like to know what the signals the ATR sends are. As you will see in the next paragraph, the ATR indicator is used to calculate a value. This value can be used to set stop-losses. You can set your stop-losses at different levels. You can use the ATR value multiplied by a certain factor to determine your stop-loss value. For example, when the result of the ATR is 1, you can set stop-losses at the stockprice - 2 (multiplier 2, for little risk) or stockprice - 5 (multiplier 5, higher risk). You can use this method for each ATR value. Think about what your multiplier should be, and you can determine your stop-loss value very easy.
Calculation of the ATR
The Average True Range is, like the name says, an average value which is calculated over different historical true ranges. So first of all, the True Range needs to be calculated. The True Range is the highest result of the three calculations below:
- True Range = Day High - Day Low
- True Range = Day High - Previous Day Close
- True Range = Previous Day Close - Day Low
Now that you know how to calculate the True Range, you can calculate the ATR. The ATR is by default calculated as a moving average of the True Ranges of the previous 14 days. The ATR is a smoother version of the True Range. The reason for this is the same as usually given for using moving averages.
Prevent false signals
As mentioned before, the ATR does not give signals (and thus no false signals). It is not a leading indicator, but just a helping indicator. The ATR can be used to determine your stop-loss values. The ATR can not be used for determining buy or sell opportunities of stocks nor for predicting the direction the price of the stock will follow.
Pros and cons for ATR
The ATR can be used as an extra indicator to complete your technical analysis model. The ATR can help you to define the levels on which you would like to sell or buy your stocks. You can set your stop-losses based on the ATR. These stop-loss levels can be determined in combination with the found support- and resistance levels found using other methods. Finally, you can use the ATR to determine whether the price of an option is right.
I could not think of any direct disadvantage or advantage myself, nor have I experienced any major (dis)advantage. But just to give you a disadvantage of the ATR indicator: you really have to think of the multiplier yourself. You are the only one who knows the risk you would like to run.
