TL;DR
Average True Range (ATR) is a commonly used technical analysis indicator for estimating market volatility over a given period. Used as a tool to determine volatility, ATR was created by technical analyst J. Welles Wilder Jr. in his book "New Concepts in Technical Trading Systems", published in 1978.
Within a 14-day period, ATR can be used to calculate and provide estimated price volatility across different true ranges to determine an average. While ATR has various benefits, including as an aid for traders to determine stop-loss prices, it does have some limitations.
Introduction
Trading is well known for its volatility, especially with cryptocurrencies. Traders often look to take advantage of these price movements and attempt to predict them. One possible method is technical analysis and price volatility indicators like Average True Range (ATR). For many traders, it's a valuable tool to understand and add to their technical analysis toolkit.
What is Average True Range?
ATR was created by technical analyst J. Welles Wilder Jr. in 1978 as a tool to measure volatility. ATR has since become one of the most well-known forms of technical volatility indicators.
It's now a significant part of other indicators that identify the directional movement of markets, such as Average Directional Movement Index (ADX) and Average Directional Movement Index Rating (ADXR). With ATR, traders try to determine an optimal period to trade volatile swings.
The indicator calculates the market's average price of assets within a 14-day range. ATR doesn't provide trend information or price direction but offers a view of price volatility during that period. A high ATR implies high price volatility during the given period, and a low ATR indicates low price volatility.
When determining if they want to buy or sell assets during the period, these low or high price volatilities are what traders consider. It's important to note that ATR only approximates price volatility and should be used solely as an aid.
How do you calculate Average True Range?
To calculate ATR, you must find a given period's greatest true range or TR. This means calculating three different ranges and picking the greatest of the three:
The latest period's high subtracted by the latest period's low
The absolute value (ignoring any negative sign) of the latest period's high minus the previous close price
The absolute value of the latest period's low minus the previous close price
The period can vary depending on the trader's focus period. For example, with crypto, the period could be 24 hours, while for stocks, it may be a single trading day. To determine the average true range over a period of time (typically 14 days), the true range is calculated for each period and summated, and a simple average is taken.
Determining the ATR of said period allows traders to learn about the volatility of asset prices during that time. Typically, a trader will see ATR displayed as a line on their charts. Below, you can see that the ATR line rises as volatility increases (in either price direction).
Why do cryptocurrency traders use Average True Range?
Cryptocurrency traders often use ATR to estimate price volatility during a period. ATR is particularly beneficial in crypto due to the high volatility seen in crypto markets. One common strategy is to use ATR to set take-profit and stop-loss orders.
When using ATR in this way, you can avoid market noise affecting your trading strategies. If you're trying to trade a suspected long-term trend, you don't want daily volatility closing your positions early.
A typical method is multiplying the ATR by 1.5 or 2, then using this figure to set the stop-loss under your entry price. The daily volatility shouldn't reach your stop-loss trigger price; if it does, it's a good indicator that the market is moving significantly downwards.
What are the drawbacks of using Average True Range?
While ATR provides benefits to its users for its adaptability and price change detection, it comes with two main disadvantages:
1. ATR is often open to interpretation. This can be a disadvantage as no single ATR value can clearly specify if a trend will be reversed or not.
2. As ATR only measures price volatility, it doesn't inform traders of the change in an asset's price direction. One example is when there is a sudden increase in ATR, some traders might believe it is confirming an old upwards or downwards trend, which can be false.
Closing thoughts
ATR is vital in many traders' toolkits for understanding volatility patterns. As volatility is a key consideration in cryptocurrency trading, it’s particularly well-suited for digital crypto assets. Its strengths lie in its simplicity, but do take note of its limitations if you decide to experiment with it in your trading activities.