Understanding the Average True Range (ATR) Indicator

What is the ATR indicator?

The Average True Range (ATR) is a technical analysis indicator used to measure the size of price fluctuations. Unlike many mainstream technical analysis indicators, the ATR is not a trend indicator. This means that the ATR does not reflect the direction of price movements—whether they're going up or down—but instead measures the magnitude of price volatility. By using the ATR indicator, investors can gain a clear understanding of the general scale of price movements, which can help them set more rational take-profit and stop-loss targets.

How is it calculated?

The true range is the greatest of the following three values (note that the last two are absolute values):

• The difference between the high and low prices of the day.

• The absolute difference between the high price of the day and the previous day's closing price.

• The absolute difference between the low price of the day and the previous day's closing price.

Once the true range is calculated, it is then smoothed by taking a moving average (typically over a default period of 14 days). This means that the ATR value represents the average true range of price movements over the most recent 14-day period.

How do we use it?

A larger ATR indicates more significant price volatility. When the ATR reaches very high values, it suggests that the price range has hit a peak, which may imply aggressive buying by major players or panic selling. It could also indicate that the phase is concluding, increasing the likelihood of a short-term market top or bottom and a potential trend reversal. At such times, the potential risks and rewards are also higher.

As the market trend becomes more established, the ATR tends to decrease. A declining ATR suggests that the price range is narrowing, and short-term market risk is reducing.

Note: The ATR should be used in conjunction with other indicators for a more comprehensive approach to trading decisions.