What is Average True Range (ATR)?

An average true range is like measuring how far you can jump…

Let’s say you wanted to know how far you could jump. You could draw a line on the ground, run toward it, and jump as far as you can. After marking where you land, you could measure the distance from the line to the landing spot. After making a few of these jumps, you could calculate your average distance. Of course, you might occasionally start your jump from behind the line. In that case, your true average distance would be a bit longer. Average true range works the same way, since it’s an average that takes into account different starting points.

An average true range (ATR) tells an investor how much a stock’s price has been moving around. It is a measure of volatility used in technical analysis (the use of charts and statistics to predict price fluctuations). The range of any day’s price movements is the difference between the highest and the lowest trading price of the day.

However, this simple daily range neglects the price movements that occur outside of active trading. In many situations, a stock price may open at a different level than where it had previously closed, leaving a gap in the price movements. For this reason, J. Welles Wilder created the ATR value as a technical indicator to more accurately capture market volatility.

For instance, if a stock closed at $100 on Tuesday night and opened at $105 on Wednesday morning, the stock is said to have gapped up $5. Unless the price falls below $105 during Wednesday’s trading, the simple daily range will start at the open price. However, this range neglects the gap. The true range captures the gap by measuring from the lesser of the daily low or the previous day’s close. Likewise, if a stock gaps down, the true range starts from whichever is greater — the daily high or the previous close.

The ATR is the moving average (an updating average that replaces the oldest date with the latest one each period) of these true daily ranges. Traditionally, analysts use the 14-day moving average, but they could also use a longer or shorter time frame. There are also different methods of calculating the moving average. Analysts may use a simple moving average or opt to place more weight on more recent observations using an exponential moving average.

Calculating the ATR requires you to have some data going back as far as the timeframe you want to use. For a 14-day ATR, you need the open, close, high, and low price from the last 14 trading days. Next, you calculate the absolute value of three differences for each day:

• Current high minus the current low
• Current high minus the previous close
• Current low minus the previous close

For each day, take the greatest of the three values (use the absolute value by ignoring any negative signs). That number is the true range value for that day. Now, add up the results from the 14 days, then divide that total by 14 to get the average. The result is the simple 14-day current ATR.

There’s an alternative approach to figuring out the true range for each day that doesn’t require you to make those three separate calculations. Instead, just use the first equation — the daily high minus the low. Then, compare the previous close to the daily high, and use the larger of the two. Next, compare the previous close to the current low, and use whichever is smaller. Once you’ve figured out the best true range for each of the 14 days, take the average, and that gives you the ATR. The next day, the 14th day would fall out of the ATR and the current day would enter the equation.

The ATR is a volatility indicator that tells you how much a stock price is moving from day to day. That is, it’s a measure of the stock’s volatility. But it doesn’t indicate the direction that a stock is trending. Rather, it shows the magnitude of price movements. Technical analysts use this information to predict future volatility and to set an expectation of normal price movements. Various trading strategies rely on this type of information to decide the right time to buy or sell a stock.

An ATR indicator is a visualization tool that is used on many trading platforms. A stock price chart will typically display candlesticks (a box-and-shadow figure that signifies the high, low, open, and close for each day) for a selected timeframe. If you turn on the ATR indicator, it usually appears below the price chart.

The ATR is a line chart that displays the changes in volatility. When the line is lower, it indicates that prices aren’t moving a lot. When it moves higher, it signals that the stock’s price has started moving more.

Some traders use an ATR indicator to look for buying or selling opportunities. Because the ATR moves up and down over time, a low-volatility period should theoretically be followed by a period of higher volatility at some point in the future. Some traders might look for low ATR as an indication that the stock is about to break out (move outside of its typical trading range). But the directional movement of the ATR doesn't say anything about the direction of the price — it only measures how much the stock is moving. If a stock is already falling, an increasing ATR could signal a more severe price decline. However, if the price is climbing at the same time the ATR is increasing, it might be viewed as a bullish (positive) sign.

Another common use of the ATR is to determine an exit point (the price at which you would sell) for a stock you own. Under this method, called a chandelier exit, a trader would set a stop-loss order (a conditional request that tells a broker to sell a stock if the price falls below a specific price). The trader determines the stop point using a multiple of the ATR. Since the ATR demonstrates normal price fluctuations, the stop-loss would only get triggered if the price goes below expected levels. The final piece to the strategy is to update the exit point if prices climb — called a trailing stop-loss. That way, the stop price always hangs off the highest point in the stock’s recent trading pattern.

For example, assume a stock is trading around $40 and that the highest price in the last three weeks was $43, with an ATR of $2. A chandelier exit strategy might suggest setting a stop-loss order at three times the ATR, which is $6. This situation would call for placing a stop-loss at $37 ($43 minus $6). If the price increases to $45 tomorrow, the stop-loss would move up to $39. The stop-loss should not decrease if prices fall, otherwise that would defeat the purpose of the strategy to limit potential losses.

An ATR period is the number of days, weeks, months, or years included in the moving average. It is traditionally 14 days but can be longer or shorter. A more extended ATR timeframe (20 to 50 periods) would be less responsive near-term changes. Therefore, only significant changes would register. A short ATR timeframe (five to 10 periods) will follow short-term volatility, which could make it less reliable.

The ATR has limitations — No measure is perfect. Statistics rely on information from the past to make guesses about the future, but the future isn’t always predictable. And past performance doesn’t guarantee future results.

It’s also important to remember that ATR doesn’t signify a trend. It only shows volatility levels, not the direction the stock is moving. Nor does ATR capture momentum, or necessarily signify a new trend is forming. It’s possible for volatility to increase by jumping up and down without breaking out in a new fundamental direction.

Every measure of volatility provides different information and insight, and there is no single best tool to use. Traders often combine several pieces of information to develop a forecast of what will happen next. The ATR is one measure of volatility. It shows how a stock’s price swings change over time.

Standard deviation is another popular measure of volatility. It shows how much a price varies day-to-day from its historical average. Stock charts sometimes display the simple moving average of a stock’s price, along with lines that are one standard deviation above and below the average (called Bollinger Bands). The width of the band is an indication of typical volatility.

Beta is another measure of volatility. It compares the size of the price movements of one stock to the rest of the stock market. A beta of 1 would indicate that the stock tends to move in line with the overall market, while above or below that level indicates its more or less volatile than the market. A beta of zero would suggest the price doesn’t change at all.

Technical analysis is an advanced concept. You should fully research this and other approaches, such as fundamental analysis, before investing.