Average True Range (ATR) is a technical analysis indicator that measures financial market volatility. This theory was developed by J. Welles Wilder and it is commonly used by analyst and investors to assess the level of price volatility in a particular security or market. ATR takes into account the range between the high and low prices of a stock over a specified length of time and provides an average value that represents the volatility.
How ATR is calculated:
Calculate the True Range (TR) for each period. The TR is the chief of the following three values:
- The difference between high of the current period and low prices.
- The absolute value of the difference between the current period's high and the previous period's close.
- The absolute value of the difference between the current period's low and the previous period's close.
- TR = Max [(High - Low), Abs(High - Previous Close), Abs(Low - Previous Close)]
- ATR = Average of TR over a specified period
- For example, let's calculate the ATR for a stock over a 14-day period:
- Day 1: High = Tk. 50, Low = Tk. 45, Previous Close = Tk. 48
- True Range (TR) = Max[(50 - 45), Abs(50 - 48), Abs(45 - 48)] = Max[5, 2, 3] = 5
- Average True Range (ATR) = TR = 5
- Continuing this calculation for the remaining days in the 14-day period will give you the ATR for each day.
The ATR value represents the average volatility of the stock over the specified period. A higher ATR suggests higher volatility indicating larger price swings, while a lower ATR indicates lower volatility and smaller price swings.
Analyst or investors can use ATR in various ways. For example, it can help set stop-loss levels as a wider ATR might require a larger buffer to protect against price fluctuations. Additionally, ATR can be used to determine position sizing with larger ATR values potentially justifying smaller position sizes to account for higher volatility.
It is important to note that, the choice of the period for calculating ATR depends on the investor's preference and the timeframe being analyzed. Common periods include 7, 14 or 21 days but they can be adjusted based on individual trading strategies and preferences.
