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Is ATR a good indicator?

atr indicator

The average True Range (ATR) developed by J. Welles Wilder, it is measures volatility, taking into account any gaps in the price movement. Typically, the ATR calculation is based on 14 periods, which can be intraday, daily, weekly, or monthly. To measure recent volatility, use a shorter average, such as 2 to 10 periods. For longer-term volatility, use 20 to 50 periods.

 

Is ATR a good indicator?
How does this indicator work?
True Range
Why is the Average True Range strategy useful for traders?
Absolute ATR
Limitations of Average True Range

 

Is ATR a good indicator?

It is a useful indicator for long-term investors to monitor because they should expect times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods of time.

 

How does this indicator work?

The Average True Range (ATR) is an indicator that measures volatility. As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind.

An expanding ATR indicates increased market volatility, with each bar’s range getting larger. A reversal in price with an increase in ATR would indicate the strength behind that move. ATR is not directional, so an expanding ATR can indicate selling pressure or buying pressure. High ATR values usually result from a sharp advance or decline and are unlikely to be sustained for extended periods.

A low ATR value indicates a series of periods with small ranges (quiet days). These low ATR values are found during extended sideways price action, thus the lower volatility. A prolonged period of low ATR values may indicate a consolidation area and the possibility of a continuation move or reversal.

ATR is very useful for stops or entry triggers, signaling changes in volatility. Whereas fixed dollar-point or percentage stops will not allow for volatility, the ATR stop will adapt to sharp price moves or consolidation areas, which can trigger an abnormal price movement in either direction. Use a multiple of ATR, such as 1.5 x ATR, to catch these abnormal price moves.

 

True Range

Wilder started with a concept called True Range (TR), which is defined as the greatest of the following:

 

  • Method 1: Current High less the current Low
  • Method 2: Current High less the previous Close (absolute value)
  • Method 3: Current Low less the previous Close (absolute value)

 

Absolute values are used to ensure positive numbers. After all, Wilder was interested in measuring the distance between two points, not the direction. If the current period’s high is above the prior period’s high and the low is below the prior period’s low, then the current period’s high-low range will be used as the True Range. This is an outside day that would use Method 1 to calculate the TR. This is pretty straightforward. Methods 2 and 3 are used when there is a gap or an inside day. A gap occurs when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move).

 

Why is the Average True Range strategy useful for traders?

Simply put, a stock experiencing a high level of volatility has a higher ATR, and a stock with lower volatility has a lower ATR. Traders may use the indicator to enter and exit trades to put a stop to loss and take profit orders. The Average True Range trading strategy can be of great help when it comes to making trading decisions.

 

The ATR indicator is most commonly used as a stop-loss tool. When the ATR is high, traders are prepared for greater volatility and broader price fluctuations. Therefore, they would set their stop-loss orders further away to avoid being kicked out of the trade prematurely. Vice versa, when the ATR indicates lower volatility, traders may use a closer stop loss.

 

Absolute ATR

Based on True Ranges, which use absolute price changes, the Average True Range indicator reflects volatility as an absolute level. It means that the ATR is not reflected as a percentage of the current close. It means that high-priced stocks will have higher ATR than low-priced stocks. For example, a $400-500 stock will have a higher ATR value than a $40-50 stock. Therefore, the ATR values are not comparable.

 

Limitations of Average True Range

Using ATR in your trading practice, remember that it is not a directional indicator like MACD or RSI, and measures only volatility. Moreover, the ATR is a subjective measure and it can’t be used as a standalone indicator, giving you some insights into whether the trend is about to reverse or not. Still, the ATR is a great tool, when it comes to adapting to an ever-changing market environment.

 

A bullish reversal with an increase in ATR would show strong buying pressure and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break.

  

Summary

 the ATR could be a powerful tool in your trading arsenal to get the most from volatile markets. At the end of the day, the predictive nature of the ATR indicator can provide us with precise risk management parameters and also with reasonable price targets.

 

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