Oscillator Indicator: Average True Range (ATR)
ATR is a volatility indicator developed by J. Welles Wilder and is used to measure the volatility or level of price movements of a security. This was introduced in Wilder’s book, New Concepts in Technical Trading Systems in 1978. Originally designed for commodity trading, which often encountered gaps and limited movement. As a result, the ATR takes into account the gap, limiting the movement and low low small distance in determining the ‘actual’ commodity range.
However, ATR is based on absolute value in price rather than percentage change. Therefore commodities with higher prices tend to have higher ATRs than commodities at lower prices.
Although ATR is designed for commodity trading, it can also be used for other securities, such as stocks and derivatives such as single stock futures (SSF) and index futures.
There are two steps in ATR calculation: First, the actual distance (TR) of the specified securities; and Second, a moving average (MA) is used to refine the ATR, but the moving average is not the moving average of the TR.
TR is the largest of the following:
TR = High – Low
TR = abs (high – close before)
TR = abs (low – close before)
Once TR is determined, we multiply the previous ATR by an average period of less than one, add it to the current ATR and divide it by the average period.
So, if using the default period of 14 then ATR will be calculated as follows:
ATR = ((ATR previous x 13) + TR current) / 14
ATR does not provide bullish or bearish direction but is a strong indicator of breakout prices as strong securities price movements are often accompanied by a large price range, especially at the start of the movement. Thus, ATR can be used as an additional indicator to confirm the breakout price.
If ATR increases, support or trend for the breakout price also increases. ATR can also be used as a guide to determine the stop loss level because securities with higher ATRs will require a higher stop loss.