Why the Average True Range (ATR) differs from other Indicators

ATR is commonly used to show Volatility, one of the most important concepts in the financial market

Volatility it is loved and hated in equal measure by traders. There are some who specialize in making money when the markets are volatile (our guide about this) and others who love it in a period of low volatility.

There are several ways of seeing whether a market is volatile or not:

➤ First, you can observe the market visually to see your preferred assets are trading.

➤ Second, Wall Street traders observe the CBOE volatility index (VIX). This is one of the most commonly-used tools.

➤ Third, you can use the many volatility-based indicators to measure volatility.

In this article we will look at one of them: the Average True Range (ATR).

→ How to Maximize Returns when Trading the Market Volatility

What is the Average True Range?

The Average True Range (ATR) is one of the many indicators that was developed by Alexander Wilder. He first wrote about the indicator in his book, New Concepts in Technical Trading Systems.

Other indicators that he suggested were the Relative Strength Index (RSI), Parabolic SAR, and the Directional Movement index.

These indicators were developed with commodities being in mind (Wilder was known for being a successful trader in corn and energies).

Commodities are also known to be more volatile than stocks. Therefore, this volatility leads to significant gaps and limit moves.

Welder’s goal was to capture the missing volatility.

ATR Formula

The Average True Range is calculated using a very simple formula:

The most commonly used period is 14.

As with most indicators, it is not mandatory that you know how they are derived. What you need are three things:

• How to apply them on a chart
• Change the period to suit your trading strategy
• How to interpret the indicator

How to Use the Average True Range

The ATR is an indicator that is significantly different from other indicators we have covered. This is because it is not used entirely to predict where the asset is moving. It is also not used to show whether an asset is overbought or oversold.

Instead, it is used to show whether there is volatility in the market or not.

So, how do you use the Average True Range?

When the market is consolidating, the ATR usually shows no major moves. This is because there is no volatility. If the price breaks out and starts moving lower, you can use the ATR to validate whether there is enthusiasm in the market about it.

A good example of the Average True Range indicator at work is shown in the UK100 chart above.

As you can see, the indicator showed little movements when the index was in consolidating. It started moving higher when the index started to decline. This is an indication that there was enthusiasm about the new downward trend.

Therefore, the key point to the ATR is that is that it is not an indicator that tells you directly what to buy or sell. As such, you should aim to combine it with other indicators like the moving averages and the RSI.

External useful resources

Average True Range (ATR) – StockCharts

How to Read and Apply the ATR Indicator for Stock Trading – Speedtrader