Average True Range Explained

On a scale of 1-10, how scared are you of volatility? ☠️

For many investors, nothing can be scarier than volatility, especially if we don’t fully understand how it works. 

Thanks to J. Welles Wilder Jr., the brains behind Average True Range (ATR), understanding volatility is as easy as connecting the dots to reveal the hidden picture. 

And the hidden picture can be exciting. 💰

Applying ATR to your strategy can help you make lucrative trades when the market goes up or down. And since some analysts expect commodities will be highly volatile in the future, why not start now? 

Rather than panic trade because your robo-advisor tells you to buy or sell a highly volatile security, take a breath and learn how to use ATR to your advantage. Plus, it’s good to know when to trust a robot. 

To incorporate ATR into your trading strategy, it is important to know what ATR is and how to use it. In the following, we’ll tackle the what and the how and provide useful ATR trading strategy. 

What you’ll learn

• What is Average True Range?
• ATR Uses, Past and Present
• Calculating ATR
• How ATR Improves Trading
• The Formula for ARC
• Benefits of ARC
• Strategy: ATR Trailing Stop Loss
• ATR's Limitations
• Average True Range: FAQs
• Get Started with a Broker

What is Average True Range? 🔎

The average true range (ATR) measures the volatility of a security, and it can be one of the many tools used to research stocks and to spot breakouts. More specifically, ATR combines a security’s price range with a moving average, which is expressed as a dollar amount. 

In other words, ATR represents the price movement of a security during a specific timeframe. For instance, throughout the month of March, Dogecoin (DOGE), on average, moved less than a cent a day (.007). By the minute, DOGE moved even less (.0002).

Some analysts claim this stretch of low volatility delayed DOGE’s 20% breakout, which could be possible, since the memecoin’s ATR spiked on April fools day—and that’s no joke. DOGE went from moving an average of .0001 a minute to .0008 a minute. And who is heedless enough to dismiss a fraction of a cent?

While DOGE’s range may not seem very wide, keep in mind that ATR is based on absolute price changes, not percentages. Because a ten-dollar price range is not as significant for a stock worth $500/share than it is for a stock worth $50/share, higher priced stocks tend to have a higher ATR.

Moreover, ATR is directly proportional to a security’s price range, but increased volatility can come from buying or selling pressure. If a security’s ATR jumped from 20 cents to a dollar, it could be a sign of a massive sell off or a massive buy in. 

When reading stock charts, once the ATR indicator is turned on, you can usually view it as a line graph below the volume indicator. When the ATR line is as flat as the Kansas plains, volatility is low and the price range is minimal. Less volatile ranges are usually seen at a market top or during a consolidation period. 

Volatile ranges often occur at a market bottom. When the ATR indicator resembles Mount Everest, volatility is high. 

Beware that a chart can look very different depending on the ATR’s interval setting. If you are just learning the fundamentals of day trading, note that the market is most volatile at opening. 

ATR Uses Past and Present 🕰

Since ATR is now used in nearly every market, the top commodity, stock, currency, and the leading forex brokerages will have an ATR indicator to help your trading strategy, but this wasn’t always the case. 

When Wilder published New Concepts in Technical Trading Systems in 1978, securities certificates had only recently been digitized and the internet was nothing if not purely fictional. During this time, Wilder traded commodities. 

If market volatility were gauged like salsa, stocks would be hot and commodities would be flaming. Commodities have more price gaps (a significant difference between a commodity’s closing price and opening price) and limit days (when a commodity’s buying or selling price is regulated). 

Price gaps and limit days can cause simple high-low ranges to be inaccurate. Thus, Wilder devised a way to account for gap and limit days and to find a security’s true maximum range.

How to Calculate Average True Range? ➗

Traders can make ATR appear on a chart with a simple click of an indicator option, which makes employing popular stock trading methods even easier. But just because a robot will calculate ATR for you doesn’t mean it isn’t worthwhile to know how it is done. 

Understanding the math will not only give you another parlor trick to put up your sleeve but will also help you get the most out of technical analysis. After all, the computer-generated ATR won’t tell you the specific settings to use, and if everyone used the default settings, the market might look more like the Suez Canal than Wall Street.

Step One: Find the True Range of One Day ✔️

A security’s single day true range is essentially its maximum price range. Therefore, to find a single day’s true range, analysts look to see which of the following has the greatest value:

1. The difference between the day’s high and low. 
2. The difference between the day’s high and the previous day’s close.
3. The difference between the day’s low and the previous day’s close.

Step Two: Find the Initial ATR (Average True Range) ✔️

Analysts can’t learn much from the range of a single interval. A single-interval range imparts as much data as an oarless rower provides power. Analysts need a fully-equipped crew, so they find the true range of several intervals and calculate the average. 

Any number of intervals can be used to find the average, although day traders will want fewer intervals than long-term investors who ride out volatile times. The more intervals used to obtain the average, the smoother the ATR indicator will be and the fewer trading signals it will produce. 

Using fewer intervals to obtain the average will cause the ATR to produce as many signals as a shark has teeth. So if you’re worried you’ll capsize in dangerous water, remember there is safety in numbers. In the following example, we use 7 days. 

Once the true range has been obtained from each day, add them up and divide by 7. This provides the ATR for day 7. Wilder provides the following example: 

Step Three: Find the ATR for Subsequent Days ✔️

To find the latest ATR (for day 8 and beyond), use the previous ATR and multiply it by 6. For those of us who are mathematically challenged, we might be wondering why we use 6. 

We use 6 because after we multiply it by the previous ATR, we add the latest/current day’s true range. This keeps the ATR based on a 7-day average. To get the ATR of day 8, the following equation is used:

Continuing with Wilder’s example, the ATR of day 8 is 1.31. 

This is quite a mouthful (and can make one’s brain hurt), but don’t worry. Thanks to modern technology, every trading platform can make these calculations for us. But, if math had morals, the moral of the equation is that you shouldn’t rely on short ranges. An ATR with a longer time frame is usually a better indicator of a security’s long term future.

How ATR Improves Trading ✅

The most basic function of ATR is to illustrate the volatility level and price movement of a security, which can help a trader decide if they enter or exit a position. When CFOs look to shareholders as volatility soars, knowing when to time a position is crucial. Let’s imagine a trader sees a strong buy signal on a stock called XYZ, but the ATR has gone from 8.10 to 50.10 in a day.

If the current price range is 90 (or any range resembling a skyscraper), it is unlikely the price will continue going up because the price movement has already more than doubled the average. In this case, a trader might be better off selling, shorting, or making an options trade with the stock. 

Similarly, a trader might ignore a strong sell signal if the price of a stock is near its low and has an unusually high ATR. Since it is unlikely the price will drop even further and make the range and ATR even greater, there is a good chance the price will rise. 

In any case, a trader might want to investigate why a security has an unusually high ATR before they buy or sell. Recent news can often cause high ATR. For example, many analysts argue the Biden administration’s infrastructure plan could cause industrial stocks to surge. 

ATR can also help a trader estimate how long it will take to reach a profit target.

To illustrate this, consider that GE moves an average of two-cents a minute. A trader who purchases the stock and believes the price will rise can expect it to take about five minutes for the price to increase by ten-cents. Although some analysts suggest traders should not attempt to time the stock market. 

While ATR is useful by itself, it becomes fully functional when multiplied by a constant (C). The result is ARC (Average Range Constant). Think of ARC as your ally who is always two steps ahead, keeping you and your money safe.

How to Calculate ARC 💭

Theoretically, the constant can be any number, although the higher the constant is, the less effective the ARC will be at stopping losses. The lower the constant is, the less effective the ARC will be at keeping a trade open and profitable. Wilder recommends using a number between 2.80 and 3.10.

Since cryptocurrencies are virtually synonymous with high volatility, let’s take Litecoin (LTC) as an example. The ATR of Litecoin is 12.13. Using a constant of 2, the ARC is 24.26. Now let’s examine how to use ARC.

The Benefits of Incorporating ARC 💡

Traders often add or subtract the ARC from a security’s close price to decide whether or not to enter, exit, or reverse a position. For long positions, they add the ARC to the close price. For short positions, they subtract the ARC from the close price.

For instance, if an investor wanted to buy LTC on an up trend, they would add 24.26 to the most recent close of $195.73. In this case, the investor’s entry target is $219.99. When the price reaches the target, it is time to buy. 

When reversing a position from long to short, a trader waits for a security to close at one ARC below the highest close since they purchased the shares. Let’s make this less confusing with a fictional scenario. 

Since a trader has owned XYZ, the highest close was $20. If the ARC is 5.0, the trader will stop and reverse their position when XYZ closes at $15 or less. When reversing from short to long, the stop and reverse point is one ARC above the lowest close.

Strategy—ATR Trailing Stop Loss 💨

What goes up but never comes down? A trailing stop on a long position—it’s kind of like a levitating magician that helps limit loss, protect gains, and stay in a trade longer.

For example, let’s say a trader purchased a share of Riot Blockchain at $4.00 with an ATR of .36 and an ARC of .72. When the trader decides to sell, they place a trailing stop loss order and sets the trailing stop to .72. 

As the stock price increases, the stop follows at its set trailing amount. As long as the price continues upward, the trader remains invested. When the price falls below the trailing stop, the shares are sold at the stop price. 

ATR Smoothing Options

ATR indicators provide “smoothing” options, which are calculated in slightly different ways. Some of these options include: 

• RMA (relative moving average)
• SMA (simple moving average)
• EMA (exponential moving average) 
• WMA (Wilder’s smoothing average)
  

In Closing: Limitations of Average True Range ⚠️

While ATR seems as wondrous as Donald Duck voyaging through Mathmagic Land, it is important to remember ATR provides objective data a trader interprets subjectively. In other words, ATR is not an oracle that predicts breakouts and price trends but a tool that measures volatility and price movement.

Rather, like many other indicators, the ATR can give you a price range in which the chances of an accurate price prediction are higher, mathematically speaking. However, the world of trading is a world of black swans and impulsive investors, so no mathematical model is impervious to the irrational nature of the public markets.

Get Started with a Stock Broker

At this point, you’re an average true range pro! 👨‍🔬 The only aspect just as important as your trading strategy, is the quality of the broker you trade with.

Here are a few brokers trusted by traders around the globe.

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8.0/10 Visit Interactive Brokers on Interactive Brokers' website

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Fees

Account minimum

$0

$0

$500

Commissions

$0

Vary

$0

Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0

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General

Best for

Active options and penny stock trading

Active traders

Beginners and mutual fund investors

Highlight

Powerful tools for professionals

Huge discounts for high-volume trading

Low fees

Promotion

50% Off Future

Rating

8.0/10 Visit TradeStation on TradeStation's website

8.0/10 Visit Interactive Brokers on Interactive Brokers' website

9.5/10 Visit Firstrade on Firstrade's website

About the author

Tina Mitchell

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Tina Mitchell is a freelance writer with a Ph.D. from the University of Louisiana at Lafayette, where she also taught for fifteen years. After working as a research assistant and writer for the Financial Transitionist Institute, she learned how economic illiteracy was hindering people in various life stages. Writing for The Tokenist, she hopes to empower readers to take control of their financial destinies. In addition to her work as a freelancer, she cofounded im-possible, a nonprofit, transdisciplinary think tank that focuses on posthumanism and our developing human condition. She is also the editor of an award-winning journal focused on the dialectics of the human and its environments. When she is not working or sailing, she is likely planning her next prank or hugging a tree.