Understanding Average True Range (ATR) in Technical Analysis

Developed by J. Welles Wilder, the Average True Range (ATR) is an indicator designed to measure volatility. Unlike other indicators, ATR was created with commodities and daily price movements in mind. Commodities are typically more volatile than stocks, often subject to gaps and limit moves due to the maximum allowed session movements.

A traditional volatility formula based solely on the high-low range does not account for gap or limit moves. To capture the true volatility, Wilder introduced the Average True Range (ATR), which measures volatility while taking into account any gaps in price movements.

The Calculation of ATR

ATR is calculated as the average of true ranges over a specified period. The true range for any given day is the greatest of the following three values:

The difference between the high and low price (High - Low) The difference between the current high and the previous close (High - Previous Close) The difference between the previous close and the low price (Previous Close - Low)

After determining the true range for each day, the ATR is calculated as the simple average of these true ranges over the selected period. During periods of high panic or price depreciation, the ATR generally increases, signaling heightened volatility. Conversely, steady uptrends or downtrends will cause the ATR to decrease.

Types of Volatility and Their Implications

Volatility can be broadly classified into several types:

Historical Volatility: The realized volatility over a specific period, often used to predict future volatility. Implied Volatility: The expected future volatility as perceived by market participants, derived from option pricing models like the Black-Scholes model. Forward Volatility: The volatility expected over a future time period. Actual Volatility: The current level of price movement. This type of volatility is often referred to as local volatility, due to it being time-specific and difficult to calculate.

The most basic form of volatility involves the standard deviation, which is a common statistical measure and essential in technical indicators such as Bollinger Bands. Before diving into standard deviation, it's essential to understand its precursor, variance.

Variance and Standard Deviation

Variance is a statistical measure of dispersion, calculated as the squared deviations from the mean. Taking the square of the deviations ensures that the distance from the mean is non-negative. To make the measure comparable to the original data, the square root of the variance is taken, yielding the standard deviation. The formulas are as follows:

[Variance Formula]

[Standard Deviation Formula]

In technical analysis, the Average True Range (ATR) serves as a lagging indicator that provides insights into historical trailing volatility. While it may not indicate the direction of price movement, it can indicate the level of current and past volatility. This makes it useful for traders to gauge market conditions and set appropriate stop-loss parameters.

Practical Applications of ATR in Trading

A simple yet effective way to use ATR is by comparing it to a moving average. If the ATR remains above a moving average (e.g., 20-period or even 300-period), the market is considered volatile, and traders may want to expand their stop-loss margin. Conversely, if the ATR shows low levels, traders can set stop-loss levels more closely aligned with their capital limits.

Using ATR in MetaTrader 5

In MetaTrader 5, you can easily visualize and analyze ATR values with the help of moving averages. Here's a step-by-step guide to adding an ATR indicator with a moving average:

Display the ATR indicator for the desired time frame (e.g., EURUSD daily values). Open the Navigator pane by going to View → Navigator. Drag and drop the Moving Average indicator into the ATR’s chart window. Select “First Indicator’s Data” from the “Apply to” dropdown menu to apply the moving average to the ATR. Adjust the settings as needed to observe the ATR and moving average together.

By using this method, traders can make informed decisions based on the ATR levels relative to moving averages. For instance, as long as the ATR remains below its moving average, the prevailing bullish trend is likely to continue.

Conclusion

The Average True Range (ATR) is a valuable tool in technical analysis, providing insights into the volatility of financial instruments. By understanding how to calculate and interpret ATR, traders can better navigate market conditions and make more informed trading decisions. Whether you're a seasoned trader or a beginner, mastering ATR can significantly enhance your trading strategy.