Average True Range ATR was developed by J. Welles Wilder and introduced in his book: New Concepts in Technical Trading Systems.
Wilder designed ATR with commodities and daily prices in mind. Commodities are frequently more volatile than big board stocks. This makes the ATR perfect for penny stocks, as pennystocks tend to be much more volatile, just like commodities.
Commodities are also prone to big gaps, much like penny stocks. It was due to these big moves and gaps in commodities that Wilder designed the ATR to capture volatility from gaps and limit moves.
We use ATR to get an indication of volatility, not an indication of price movement or momentum.
Wilder started with a concept called True Range (TR), which is defined as the greatest of the following:
Current high minus the current low
Current high minus the previous close
Curent low minus the previous close
The latter two are considered "Absolute Values". Absolute values are used to ensure positive numbers. Wilder was not concerned with the direction of the price, as he wanted to measure volatility he was more concerned with the distance or range, hence why he came up with True Range and why he used it as the basis for ATR.
ATR is not a directional indicator, like MACD or RSI. Instead, ATR is a unique volatility indicator that reflects the degree of interest or disinterest in a move. Strong moves, in either direction, are often accompanied by large ranges, or large True Ranges. This is especially true at the beginning of a move. Insignificant moves can be accompanied by relatively narrow ranges. Therefore, ATR can be used to judge the fervor behind a move or breakout. A bullish reversal with an increase in ATR would show strong buying pressure and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break.
As with all other indicators, don't just rely on the defaults, adjust your indicators to suit the stock you are looking at and your trading style.
Typically shorter look backs (lower #'s on your indicators) give you quicker signals which is good for aggressive traders, while longer look backs (higher #'s on your indicators) give slower but more reliable signals for traders who are more conservative.
As we always say: "Don't use your hard earned cash to find out what kind of trader you are, use a virtual account for that."
Links for free virtual trading sites can be found on our Resources page:
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The ATR is calculated using the following formula:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
- Multiply the previous 14-day ATR by 13.
- Add the most recent day's TR value.
- Divide the total by 14