What is average true range (ATR): how to measure crypto volatility

Average true range (ATR) is a technical analysis indicator that measures the volatility of an asset. It was developed by J. Welles Wilder Jr. and published in his book "New Concepts in Technical Trading Systems" in 1978. ATR is designed to give traders an idea of how much a price has moved on average during a given time period.

It's considered one of the most reliable indicators of volatility because it takes into account any gaps or limit moves that may occur in the price of an asset. Traders use ATR to identify potential trend changes, determine stop-loss levels, and assess the risk/reward ratio of a trade.

In this article, we'll explain what average true range is, the benefits and drawbacks of ATR, and how to use average true range in crypto trading.

TL;DR

• First proposed in 1978, average true range (ATR) provides a measure of the average movement of an asset's price across a specific time period.

• Traders use ATR to measure volatility, identify potential trend changes, set stop-loss levels, and decide the risk/reward ratio of a trade.

• To calculate ATR, traders also need to calculate the true range (TR). Once the TR across a selected period is known, ATR can be calculated by taking the average of the TR values across the same period.

• Although the ATR has numerous advantages, such as providing an objective view of volatility and being relatively simple to use, it is limited to historical data, and can be affected by outliers, limiting its accuracy.

• ATR should be combined with other technical analysis indicators such as bollinger bands and relative strength index, to help traders make informed decisions.

Importance of ATR

The importance of average true range (ATR) lies in its ability to provide traders with an objective measurement of market volatility. ATR can help traders understand the degree of price movement that an asset is experiencing, which can be used to make informed trading decisions. The indicator is particularly useful for traders who use stop-losses and/or take-profit orders to manage their positions. By understanding an asset's typical price range, traders can set their stop-loss and take-profit orders at appropriate levels to manage their risk.

Another important use of ATR is in assessing the risk/reward ratio of a trade. If a trader has identified a potential trade opportunity, they can use ATR to estimate the potential gain or loss of the trade. This information can be used to assess the risk/reward ratio of the trade and determine whether it is a good opportunity to pursue.

How to calculate ATR

The calculation of ATR involves two key steps: calculating the true range (TR) and then calculating the average true range (ATR).

True range (TR)

To calculate ATR, you must first calculate the TR for a specified period. The TR is the largest of the following three values:

1. The difference between the current high and the previous close.

2. The difference between the current low and the previous close.

3. The difference between the current high and the current low.

Here are the steps to calculate the TR for a given period:

1. Find the difference between the current high and the current low.

2. Find the absolute value of the difference between the current high and the previous close.

3. Find the absolute value of the difference between the current low and the previous close.

4. The TR is the largest of the three values calculated above.

For example, let's say the current high is $50, the current low is $40, and the previous close was $45. The calculation of TR would be as follows:

1. Difference between the current high and the current low = $50 - $40 = $10.

2. Absolute value of the difference between the current high and the previous close = |$50 - $45| = $5.

3. Absolute value of the difference between the current low and the previous close = |$40 - $45| = $5.

4. The largest of the three values is $10, which is the true range.

Once the TR has been calculated for a specified period, the average true range can be calculated by taking the average of the TR values over the same period. The most common period used is 14, but traders can adjust this value to suit their individual trading styles and preferences.

Average true range formula

After calculating the true range for a specified period, the next step is to calculate the average true range using the following formula:

ATR = [(Prior ATR * (n - 1)) + Current TR] / nWhere:

1. Prior ATR = the ATR value for the previous period.

2. N = the number of periods used in the calculation. The most common is based on 14 periods.

3. Current TR = the true range value for the current period.

To calculate the ATR for the first period, the TR value is used as the ATR value.For example, let's say we are calculating the ATR for a 14-day period, and we've already calculated the TR values for the first 14 days. Here are the steps to calculate the ATR for the fifteenth day:

1. Calculate the TR for the fifteenth day using the formula described above.

2. Prior ATR is the ATR value for the previous day (day 14).

3. n is 14 (the number of periods used in the calculation).

4. Substitute the values into the ATR formula to calculate the ATR for the fifteenth day.

ATR = [(Prior ATR * (n - 1)) + Current TR] / n = [(ATR for day 14 * 13) + TR for day 15] / 14

The result of this calculation is the ATR value for the fifteenth day. This process can be repeated for each subsequent day to calculate the ATR for the entire period.

What is a good average true range?

There’s no specific value that can be considered a "good" or "bad" ATR since it varies depending on the market, the asset being traded, and the trader's individual trading style and preferences. A high ATR value indicates a more volatile market, while a low ATR value indicates a less volatile market.

Traders use ATR to determine the typical price range over a specified period of time, which can help them identify stop-losses and take-profit levels, identify potential trend changes, and assess the risk/reward ratio of a trade. As a general guide, traders often look for ATR values that are higher than the average ATR value for that particular asset over a specified period.

For example, if the average ATR value over a 14-day period is $2, a trader may consider an ATR value of $2.50 or higher to be "good", as it indicates the asset is experiencing more price movement than usual. However, a trader with a different risk tolerance or trading strategy may interpret what constitutes a "good" ATR value differently.

Ultimately, the value of ATR as an indicator of market volatility and trading opportunities depends on the individual trader's interpretation and use of the information provided by the indicator.

Interpretation of ATR

Let's look now at the interpretation of ATR and how traders can use this indicator to inform their trading decisions.

Volatility indicator

Average true range is primarily used as a volatility indicator. A high ATR value indicates that the asset is experiencing greater price movement over a specified period, while a low ATR value indicates less volatility. ATR can be used to compare the volatility of different assets, and can also help identify changes in volatility over time.

Traders can use ATR to help them set stop-loss and take-profit levels and identify potential trend changes. For example, if an asset has a high ATR value, traders may set wider stop-losses and take-profit levels to account for the increased volatility. Conversely, if an asset has a low ATR value, a trader may set tighter stop-losses and take-profit levels to account for the lower volatility.

Trading strategy

In addition to its use as a volatility indicator, ATR can also be used as a basis for trading strategies. For example, traders frequently use ATR to determine the size of their trade.

Another trading strategy that incorporates the use of an ATR, is the ATR trailing stop. This strategy involves setting a stop-loss at a certain ATR value below the current price of the asset. The stop-loss order is then adjusted upwards as the price of the asset increases, based on the ATR value. This allows traders to capture more gains while limiting their losses.

Benefits of using average true range

There are several benefits of using average true range as a technical analysis indicator. These benefits include:

Objective measurement of volatility

ATR provides traders with an objective measurement of volatility, taking into account the gaps or limit moves that may impact the price of an asset. This can help traders make informed decisions about their trading strategies and risk management.

Helps identify potential trend changes

By monitoring changes in ATR over time, traders can identify potential trend changes. A significant increase or decrease in ATR can indicate a change in market conditions, which may signal a trend reversal.

Helps set an appropriate stop-loss and take-profit level

ATR can be used to help traders set appropriate stop-loss and take-profit levels based on the typical range of price movement for an asset over a specified period of time. This can help traders manage their risk and avoid significant losses.

Can be used in a variety of trading strategies

ATR can be used as a basis for a variety of trading strategies, such as the ATR trailing stop and position sizing base. This makes it a versatile tool for traders looking to manage risk and optimize their trading strategies.

Easy to use and understand

ATR is a simple and easy-to-use indicator that can be calculated using readily available charting software. Traders don’t need to have a deep understanding of complex mathematical models or technical analysis techniques to use ATR effectively.

The benefits of using ATR make it a valuable tool for traders looking to manage risk, identify potential trading opportunities, and optimize their trading strategies.

Drawbacks of using average true range

While average true range is a useful technical analysis indicator, it has some drawbacks. These drawbacks include the following:

Limited to historical data

ATR is a lagging indicator, meaning it's based on past price movements and is therefore limited to historical data. It can’t predict future price movements or changes in volatility with complete accuracy. This can make the tool less effective in volatile markets where traders typically need to react quickly.

Only measures volatility

While ATR is reliable, it doesn’t provide information about other market factors that may impact trading decisions. Traders may need to use other technical indicators and analysis techniques in conjunction with ATR to make informed trading decisions.

Requires interpretation

Like any technical analysis tool, ATR requires interpretation and analysis by the trader to be useful. The interpretation of ATR values can vary depending on the trader's individual trading style and preferences.

Can be affected by outliers

ATR can be affected by outliers, such as large price movements or gaps. These outliers can skew the ATR value and make it less useful as an indicator of typical price movement.

While ATR is a useful tool for traders, it’s important to recognize its limitations and use it in conjunction with other technical indicators and analysis techniques to make sound trading decisions.

Short term focus

ATR is generally considered better suited to short-term analysis because the tool focuses on volatility in short time frames. It may therefore not be suitable for traders who take a long-term view. For these traders, technical analysis such as exponential moving averages may be better.

How to use average true range in technical analysis

Average true range is a versatile technical analysis indicator that can be used in several ways to inform trading decisions. Here are some ways to use ATR in technical analysis:

1. Identifying volatility: ATR is primarily used to measure volatility of an asset. Traders can use ATR to identify periods of high and low volatility, which can be used to set stop-loss and take-profit levels, as well as to identify potential trend changes.

2. Setting stop-loss and take-profit levels: ATR can be used to help traders set appropriate stop-loss and take-profit levels. Traders may set wider stop-loss and take-profit levels for securities with higher ATR values to account for the increased volatility, and tighter stop-loss and take-profit levels for securities with lower ATR values to account for lower volatility.

3. Identifying potential trend changes: Traders can monitor changes in ATR over time to identify potential trend changes. A significant increase or decrease in ATR can indicate a change in market conditions, which may signal a trend reversal.

4. Aiding in position sizing: ATR can be used as a basis for position sizing, where traders adjust the size of their position based on the ATR value of the asset. This allows traders to manage their risk and optimize their trading strategy based on the volatility of their chosen asset class.

5. Using in conjunction with other technical indicators: ATR can be used together with other technical indicators, such as oscillators or moving averages, to confirm signals and identify trading opportunities. For example, if an asset is experiencing high volatility, traders may look for a moving average crossover or oscillator signal to confirm a potential trade.

ATR is a versatile tool that can be used in a variety of ways to inform technical analysis and trading decisions. Traders can adjust their trading strategies based on the ATR value to optimize their risk management and trading opportunities.

What other technical analysis tools complement ATR?

It's always wise for traders to combine multiple technical analysis tools when studying the charts, to make sure they're as informed as possible. If you're incorporating ATR into your strategy, it may be worth considering the following.

• Bollinger bands: Traders use this tool to identify potential trend reversals, breakouts, and measure price volatility. By setting a higher and lower band either side of a moving average, the tool helps traders to identify overbought or oversold conditions for an asset. As a result, bollinger bands can help traders to confirm whether localized volatility is consistent with broader market volatility.

• Relative strength index (RSI): RSI is useful when combined with ATR because it indicates the strength of a trend — something ATR doesn't show. RSI therefore gives traders a broader view when combined with ATR, as it shows how long a trend may continue for.

• Fibonacci retracement: This technical analysis indicator complements ATR by showing potential support and resistance levels. With these levels in mind, traders can then look to ATR to judge whether the retracement levels are likely to hold. For example, because high ATR points to high volatility, it suggests a level may not hold.

The final word

Average true range is a valuable technical analysis indicator that can provide traders with an objective measurement of past volatility. ATR can be used to identify potential trend changes, set appropriate stop-loss and take-profit levels, aid in position sizing, and be combined with other technical indicators to confirm signals and identify trading opportunities.

While ATR isn’t without its drawbacks, such as being limited to historical data and requiring interpretation by the trader, its benefits can make it a versatile tool for traders looking to manage risk and optimize their trading strategies.

Traders should remember that ATR is just one tool in a trader's toolbox, and shouldn’t be used alone to make informed trading decisions. By using ATR together with other analysis tools, traders can better understand the market conditions and make more informed decisions about their trades.