Introduction
When it comes to investing in the stock market, it’s important to have a good understanding of risk management. One tool that traders use to measure risk is the Average True Range (ATR). In this article, we’ll explain what the ATR is and how to calculate it.
What is Average True Range?
The Average True Range is a technical indicator that measures volatility in the market. It was developed by J. Welles Wilder Jr. in the 1970s as a way to measure the volatility of commodity markets. The ATR is calculated by taking the average of the true range over a specified period of time.
How to Calculate Average True Range
The ATR is calculated using the following formula:
ATR = [(Prior ATR x 13) + Current TR] / 14
Where:
Prior ATR = the ATR value for the previous period
Current TR = the current true range
What is True Range?
Before we can understand how to calculate the ATR, we need to understand what the true range is. The true range is the greatest of the following:
- The distance between the current high and the current low
- The distance between the previous close and the current high
- The distance between the previous close and the current low
How to Calculate True Range
The true range is calculated using the following formula:
True Range = Max[(Current High – Current Low), Abs(Current High – Previous Close), Abs(Current Low – Previous Close)]
Example Calculation
Let’s say we want to calculate the ATR for a stock over the last 14 days. Here are the steps:
- Calculate the true range for each of the 14 days
- Calculate the average of the true ranges
- Use the formula above to calculate the ATR for day 15
Why is Average True Range Important?
The ATR is important because it gives traders an idea of how much a stock is likely to move in a given period. A high ATR indicates that the stock is volatile and may be risky to trade. A low ATR indicates that the stock is less volatile and may be a safer trade.
Limitations of Average True Range
It’s important to note that the ATR is just one tool that traders use to measure risk. It’s not a perfect indicator and should be used in conjunction with other tools and analysis. Additionally, the ATR is only as good as the data used to calculate it. If the data is inaccurate, the ATR will be inaccurate as well.
Conclusion
The Average True Range is a useful tool for traders who want to manage risk in the stock market. By calculating the ATR, traders can get a better idea of how much a stock is likely to move in a given period. However, it’s important to remember that the ATR is just one tool and should be used in conjunction with other analysis and tools.
