Background: The Average True Range indicator was developed by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems. This is another measure of volatility based on price action during a given period, with a higher ATR indicating a high level of volatility and a low ATR indicating a low level of volatility.
The ATR is based on a moving average of true ranges, typically for 14 periods. True range is the greatest of:
- current high less the current low.
- absolute value of the current high less the previous close.
- absolute value of the current low less the previous close.
Purpose: ATR was developed primarily for commodities markets to measure daily price volatility. These markets are more likely to have price gaps or limit moves, meaning that a volatility formula based on only the high-low price range would not include the effects of these gap or limit moves. ATR includes this "missing" volatility using absolute values but does not indicate price direction, only reflecting the degree of interest or disinterest in a move.
Basic signals: If today's high is above yesterday's high and today's low is below yesterday's low, then today's high-low price range is used as the true range (the first alternative above).
If yesterday's close is greater than today's high or is less than today's low, then it signals a gap or limit move, and one of the other alternatives apply to determine the true range to use in calculating the ATR. At the beginning, the first TR value is simply the high minus the low, and the first 14-day ATR is the average of the daily TR values for the last 14 days. After that, the data is smoothed by incorporating the previous period's ATR value.
Strong trending moves, whether up or down, often include large price ranges or large true ranges, especially at the beginning of a move. Consequently, ATR can be used to help determine the enthusiasm behind a move or provide reinforcement for acting on a breakout.
Pro/con: ATR provides a better gauge of a market's recent price range and volatility over a given period. However, for markets that trade continuously around the clock, a steady stream of prices may reduce the need for the ATR indicator. ATR also does not provide any guidance on price direction.