Average True Range is a Moving Average of the True Range values over 'n' periods of time.
Calculation
1. TRt = MAX (|Ht - Lt|,|Ht - Ct-1|,|Lt - Ct-1|)
2. Initial (chronological) value:
ATRt = (TRt + TRt-1 + ... TRt-n+1) / n
Accumulative (subsequent) values:
ATRt = ((n-1) * ATRt-1 + TRt) / n
Parameter
Period. The number of bars in a chart. If the chart displays daily data, then period denotes days; in weekly charts, the period will stand for weeks, and so on. Wilder used a period of 7. Other common periods used are 14 and 20. This application uses a default value of 14.
Interpretation
Welles Wilder developed Average True Range to create a tool for a precise and realistic calculation of market’s price activity. This value is considered when calculating the directional movement of a market. Mr. Wilder defined the True Range to be the greatest for the following periods:
The distance from today’s high to today’s low.
The distance from yesterday’s close to today’s high.
The distance from yesterday’s close to today’s low.
True Range measures market volatility and is an integral part of indicators such as ADX (Average Directional Movement) or ADXR (Average Directional Movement Rating), and several others, to identify the directional movement of a market. The ATR is the basic unit of measurement for Wilder's Volatility System.
The Average True Range indicator identifies periods of high and low volatility in a market. High volatility describes a market with ongoing price fluctuation, whereas low volatility is used to label a market with little price activity. Measuring market volatility can help in identifying buy and sell signals and, additionally, risk potential. Markets with high price fluctuation offer more risk/reward potential, because prices rise and fall in a short time, giving the investor the opportunity to buy or sell at, supposedly, the right moment.
When a market becomes increasingly volatile, the ATR tends to peak rising in value, and during periods of little volatility, the ATR bottoms out decreasing in value. A market will usually keep the direction of the initial price move, though this is certainly not a rule. Analysts, therefore, tend to use Average True Range to measure market volatility and other technical indicators to help identify market direction.
Literature
· Wilder, J. Welles. New Concepts in Technical Trading Systems. Greensboro, NC: Trend Research, 1978.
· Schwager, Jack D. Schwager on Futures: Technical Analysis. New York, NY: John Wiley & Sons, Inc.