TL;DR
Average True Range (ATR) is a technical analysis indicator used to estimate market volatility over a given period. Used as a tool to determine volatility, the ATR was created by technical analyst J. Welles Wilder Jr. in his book "New Concepts in Technical Trading Systems", published in 1978.
Considering a 14-day period, the ATR can be used to calculate estimated price volatility across different real ranges and determine an average value. Although ATR has several benefits, including as an aid for traders in determining stop-loss prices, it has some limitations.
Introduction
Trading is known for its volatility, especially when it comes to cryptocurrencies. Traders seek to take advantage of these price movements by trying to predict them. To do this, they use technical analysis methods and price volatility indicators such as the Average True Range (ATR). For many traders, this is a valuable resource to learn and add to their technical analysis toolkit.
What is Average True Range?
The ATR was created by technical analyst J. Welles Wilder Jr. in 1978 as a tool for measuring volatility. Since then, ATR has become one of the most well-known technical indicators of volatility.
Currently, ATR is one of the important indicators that identify the directional movement of markets, such as the Average Directional Movement Index (ADX) and the Average Directional Movement Index Rating (ADXR). With ATR, traders try to determine an ideal period for trading volatile swings.
The indicator calculates the average market price of assets over a 14-day interval. The ATR does not provide information on price trends or direction, but it does offer an overview of price volatility during this period. A high ATR represents high price volatility during the given period. A low ATR indicates low price volatility.
When determining whether to buy or sell assets during the period, traders consider these levels of price volatility. It is important to note that the ATR only provides an estimate of volatility and should only be used as an auxiliary tool.
How to calculate the Average True Range?
To calculate the ATR, you must find the largest true range (True Range or TR) for a given period. To do this, you need to calculate three different intervals and choose the largest of the three:
The maximum value of the most recent period subtracted by the minimum value of the most recent period
The absolute value (ignoring any negative sign) of the last period's high minus the previous closing price
The absolute value of the most recent period's low minus the previous closing price
The period may vary depending on the trader's focus. For example, with cryptocurrencies, the period could be 24 hours, while for stocks, it could be a single trading day. To determine the average true range over a period (typically 14 days), we calculate the true range for each period, add the values, and obtain a simple average.
By determining the ATR for that period, traders obtain information about the volatility of asset prices during the respective period. Typically, the trader will see the ATR displayed as a line on their charts. Below, we can see that the ATR line rises as volatility increases (in either price direction).
Why do cryptocurrency traders use Average True Range?
Cryptocurrency traders often use ATR to estimate price volatility over a period of time. ATR is particularly useful in the cryptocurrency sector due to the high volatility seen in the markets. A common strategy is to use the ATR to set take-profit and stop-loss orders.
By using ATR in this way, you can prevent market noise from affecting your trading strategies. If you intend to trade considering a supposed long-term trend, you don't want daily volatility to close your positions early.
A common method is to multiply the ATR by 1.5 or 2 and then use that value to set the stop-loss under your entry price. Daily volatility must not reach your stop-loss activation price; if this happens, it is a good indicator that the market is on a significant downward trend.
What are the disadvantages of using Average True Range?
Although ATR offers benefits to its users through its adaptability and detection of potential price changes, it has two main disadvantages:
1. The ATR is subject to different interpretations. This can be a disadvantage, as no ATR value is able to clearly specify whether or not a trend reversal will occur.
2. Because ATR only measures volatility, it does not inform traders about changes in an asset's price direction. For example, when a sudden increase in ATR occurs, some traders may believe that the indicator is confirming an old uptrend or downtrend, which may be false.
Final considerations
The ATR is an essential tool for many traders looking to understand volatility patterns. As the volatility factor is important in cryptocurrency trading, this indicator is particularly suitable for digital cryptoassets. ATR's strengths come from its simplicity. However, be aware of its limitations if you decide to use it in your trading strategies.