The Average True Range, by definition, is a simple and fantastic measure of volatility and market noise. Interestingly, the average true range (ATR) tells you a security’s volatility over a given period. In other words, it gives you the tendency of a security to move, in either direction.
The average true range, more specifically, is the (moving) average of the true range for a given period. The true range is the greatest of the following:
- The difference between the current high and the current low
- The difference between the current high and the previous close
- The difference between the current low and the previous close
The average true range is calculated by taking an average of the true ranges over a set number of previous periods. Proper Care should be taken to use sufficient periods in the averaging process in order to obtain an average true range. Using only a small period would not provide a large enough sample to give you an accurate indication of the true range of the security’s price movement. Therefore, a more useful period to use for the average true range would be 14.
The value returned by the average true range is simply an indication as to how much a stock has moved either up or down on average over the defined period. High values are indicative of the fact that prices are changing a large amount during the day. Low values indicate that prices are staying relatively constant. An important observation is that both trending and level prices can have high or low volatility.
Now, let us explain how you can use Average true range. The only thing you need to do is to subtract a multiple of the average true range from the entry price. You might take two times the average true range and subtract it from your entry price.
Now, by going by this pre-defined point at which you sell, you know that if the share price doesn’t move in your favored direction, and actually moves against you, you already know the point at which you’re going to sell. The emotions are removed from the equation, and you just simply follow what the stop loss says. This is how most successful traders limit their losses. They know when they’re going to sell and they have this pre-defined before they even begin trading. Although their methods of calculating the average true range and the stop loss may be different the one common element here is that they have a stop loss in place.