Understanding Average True Range.

The Average True Range (ATR) is an indicator that measures volatility. A stock’s ‘range’ is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility.

Average true range is built on this principle of ‘range’. To understand ATR, you must first try the concept of ‘true range’.

What is True range?

True Range is the greatest of the following three values:
1.The difference in price between today’s high and today’s low of a stock.
2.The difference in price between yesterday’s close to today’s high.
3.The difference in price between yesterdays close to today’s low.

True range is always a positive number (negative numbers from the calculation above are to be ignored).

Average true range is simply an average of the true range- usually 14-days. Calculating the Average True Range Indicator is slightly complex, though it is possible with a spreadsheet. Fortunately, most of the trading screens provide the average true range indicator as a part of their service.

Care should be taken to use sufficient periods in the averaging process in order to obtain a suitable sample size, i.e. an average true range using only 3 days would not provide a large enough sample to give you an accurate indication of the true range of the security’s price movement. A more useful period to use for the average true range would be 14.

What does ATR indicate?

The value returned by the average true range is simply an indication as to how much a stock has moved either up or down on average over the defined period. High values indicate that prices are changing a large amount during the day. Low values indicate that prices are staying relatively constant.

The ATR (Average True Range) indicator also helps to determine the average size of the daily trading range. In other words, it tells how volatile the market is and how much does it move from one point to another during the trading day.

ATR is not a leading indicator – means it does not send signals about market direction or duration, but it gauges one of the most important market parameter – price volatility.

The logic behind ATR is that – over the last several days on average, if the stock price has moved ‘X’ points, we could safely assume that unless some shocking market news comes along, this range will remain relatively consistent.

In short, ATR indicator is a tool for short term traders.Since it shows the average price range of a share, traders also use it to place stop loss orders.

You may like these posts:

  1. Understanding Average Directional Index (ADX)
  2. Understanding Moving average
  3. Understanding Stochastic oscillators.

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