The Average True Range Indicator was Developed by J. Welles Wilder also known as (ATR) is an indicator that measures volatility.
The Average True Range Indicator works best with commodities.
Commodities are frequently more volatile than stocks. Because they trend to produce more gaps.
But the Average True Range Indicator can be and is used on all type of stocks and other markets. Just because the Average True Range Indicator was designed for Commodities don’t let that stop you from using it on stocks.
The Average True Range Indicator is a volatility formula based only on the high-low range would fail to capture volatility from gap ups and downs or limit moves.
Wilder created Average True Range Indicator to capture this “missing” volatility.It is important to keep in mind that ATR doesn’t provide an indication of price direction, just volatility.
Wilder featured the Average True Range Indicator in his book, New Concepts in Technical Trading Systems which was published in 1978.
Even though the Average True Range Indicator was developed before the computer age, Wilder’s Average True Range indicator has stood the test of time and remain highly sought after.
Wilder started by using a concept called True Range (TR), which is defined as the maximum of the following:
Method 1: Current High less the current Low
Method 2: Current High minus the previous Close (absolute value)
Method 3: Current Low less the previous Close (absolute value)
Absolute values are used to ensure positive numbers. After all, Wilder was interested in measuring the distance between two points, not just the direction.
If the current period’s high is higher than the prior period’s high as well as low is beneath the prior period’s low, then the current period’s high-low range will be used as being True Range.
This is an outside day that will use Method 1 to calculate the True Range. This is pretty clear-cut. Methods 2 as well as 3 are used when there is a gap or an inside day.
A gap happens when the previous close is greater than the current high as well as previous close is lower than the current low.
Typically, the Average True Range or ATR is based on 14 periods and can be calculated when using intraday, daily, weekly or monthly basis.
Below is the Sample Calculation of the Average True Range indicator:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
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Hope it helps