What Is Average True Range (ATR)?

Like most skilled professions, trading requires specialized tools. These range from technical indicators that measure volatility, liquidity, or momentum to financial reports that gauge a company’s value or growth potential.

Knowing when and how to use the right tool for a job can help traders manage risk and make well-informed decisions. One indicator—average true range (ATR)—ranks among the most popular volatility indicators used in technical analysis. But what is ATR, and why does it matter? 

Markets exist in constant flux, which is why understanding how to read and interpret volatility signals for all types of trading is key. Whether you’re a day trader or a buy-and-hold investor, knowing how to calculate and use ATRs will unlock a powerful new tool in your trading toolbox. 

What is the ATR indicator?

John Welles Wilder Jr. introduced the world to ATRs in his 1978 book, “New Concepts in Technical Trading Systems.” A trained mechanical engineer, Wilder made his most significant contributions in the technical analysis field. He developed several technical indicators commonly used in trading to this day, including ATR, the Relative Strength Index (RSI), Parabolic SAR, and the Average Directional Movement Index (ADX). 

Traders use the ATR indicator to track volatility over time. Although Wilder originally created ATR for commodity investment strategies, you can use ATR with any asset. As a pure volatility indicator, ATR does not indicate directional movement. Instead, traders use ATR to signal when to enter the market or where to set a stop-loss order. 

How does ATR work?

By showing how much an asset’s price changes on average during a specific period, ATR functions as a smoothed moving average for true range values. The higher the ATR, the more volatile an asset’s price movements. 

You can calculate ATR using any timeframe, but 14 days is the most popular span in trading setups. Charting ATR over a shorter period typically provides more trading signals, making minute ATR charts popular with intraday trading strategies, such as day trading. 

The ATR formula

Before calculating ATR, you must calculate the true range for each period in your desired range. The TR formula provides the steps to find an asset’s true range:

If you lack previously calculated ATRs, you must use the ATR arithmetic mean formula. 

Essentially, the arithmetic mean formula instructs you to add all the TR values in your range and divide the sum by the number of observations. 

With a previously calculated ATR, you can then plug your values into the following formula to find the current ATR at a particular moment in time:

This formula serves as an exponential moving average, with more weight given to the current (most recent) price. By calculating the current ATR, you can estimate traders’ interest in a stock. A high-ATR stock possesses high volatility, which can signal a future uptrend or downtrend in the stock’s price. Lower ATRs indicate low volatility, which may signal a sideways or neutral trend in stock price. 

Calculating ATR 

Let’s say ABC stock traded at a high-low today of $37.38 and $35.75, respectively. It previously closed at $36.53. Plug these three values into the TR formula to find the highest difference.

In this example, the TR equals $1.63 because $1.63 > $0.85 > $0.78. 

Repeat this step for every period in your sample. For the next step, assume you have the TR values for ABC stock over the past 14 days. Add the TR values together and divide the sum by 14 (the number of observations in your range) to calculate the ATR. 

This means ABC stock’s average volatility is $1.47.

The following day, suppose ABC stock records a high of $37.93, a low of $37.11, and it closed the previous day at $37.02. This results in a current TR equal to $0.82. You can now calculate the current ATR using the previous ATR and current TR.

The current day’s ATR is $1.42. Since $1.42 < $1.47, volatility fell from Day 14 to Day 15. 

Mastering ATR trading doesn’t require that you excel at math, but knowing these ATR calculation fundamentals will help you read and interpret volatility charts. 

Reasons to use ATR

Every experienced technical analyst knows there’s no such thing as a perfect indicator. Although you can use ATR to identify trends and possible reversals, it does not indicate bias in the market.

Despite its limitations, understanding ATR signals helps traders recognize when trends might form, making ATR valuable to your overall trading strategy. Here are some ways to use it:

Predicting market volatility

ATR shows how much an asset’s price moved on average over a specific period. Even though ATR does not predict future volatility, traders often use historical ATR data to determine how much an asset’s price may move in the short term. 

Identifying reversals and trend strength

In addition to determining volatility, ATR is useful for recognizing trend reversals and assessing trend strength. If ATR suddenly increases, this may signal a trend reversal. Conversely, a steady increase in ATR may indicate a strong trend. 

Suppose ABC stock’s price has declined over the past few weeks. During this period, the ATR also slowly declined. A sudden increase in ATR may suggest a trend reversal, prompting a trader to buy ABC stock.

Setting stop-loss levels

Many traders use ATR as a level when placing exit orders. This strategy involves entering a trailing stop under an asset’s highest recorded price since you took your long position using ATR as the exit trigger. The level can vary but is typically set as ATR multiplied by some constant. 

Imagine you bought ABC stock at $36 per share. You determine you should set a stop-loss order at 1.5 times the ATR below your cost basis. If the ATR is $1.47, you should place your stop loss order at $33.79 ($36 – ($1.47 ✕ 1.5)). 

Position sizing

Traders can establish appropriate position sizes by incorporating ATR and risk appetite into their trading strategy. Selecting a trade size allows you to mitigate risk and maximize potential gain. To calculate position size using ATR, divide the position size (in dollars) by the ATR value. 

Imagine you want to buy ABC stock but don’t know how many shares you should buy. You decide you can accept a loss no greater than $200 on the trade. With an ATR of $1.47, you should limit your position to 136 shares ($200 $1.47). 

Use Composer to harness volatility indicators and make smarter trading decisions

Algorithmic trading strategies leverage popular volatility indicators, such as ATR, Bollinger bands, and the CBOE Volatility Index (VIX). Composer’s no-code platform makes it easy to incorporate volatility indicators like price and return standard deviation into your trading strategy.

Use Composer’s AI feature to create volatility-based strategies or explore strategies made by other Composer members. Start trading with Composer and discover how volatility indicators can improve your trading strategy.