What Is the Average True Range (ATR)?

The average true range (ATR) is a technical analysis indicator introduced by market technician J. Welles Wilder Jr. in his book New Concepts in Technical Trading Systems.

It measures market volatility by decomposing the entire range of an asset price for that period.

The true range indicator is taken as the greatest of the following: current high less the current low, the absolute value of the current high less the previous close, and the absolute value of the current low less the previous close.

The ATR is then a moving average, generally using 14 days, of the true ranges.

The Average True Range (ATR) Formula

The formula to calculate ATR for an investment with a previous ATR calculation is:

Previous ATR=(Previous ATR(n−1))+TRn\text{Previous ATR} = \frac{(\text{Previous ATR}(n – 1)) + TR}{n}Previous ATR=n(Previous ATR(n−1))+TR​

Where:
n = Number of periods
TR = True range

If there is not a previous ATR calculated, you must use:

1n∑inTRi\frac{1}{n} \sum_{i}^n TR_in1​∑in​TRi​

Where:
TR = Particular true range (first day’s TR, second, third, etc.)
n = Number of periods

To calculate the true range, use the following formula:

TR=Max[(H−L),∣H−Cp∣,∣L−Cp∣]TR = \text{Max}[(H – L), \left| H – C_p \right|, \left| L – C_p \right|]TR=Max[(H−L),∣H−Cp​∣,∣L−Cp​∣]

Where:
H = Today’s high
L = Today’s low
C_p = Yesterday’s closing price
Max = Highest value of the three terms

How to Calculate the ATR

To calculate ATR, start by finding the true range values for each day.
The true range for a day is the highest of:

• Today’s high minus the low
• The absolute value of today’s high minus yesterday’s close
• The absolute value of today’s low minus yesterday’s close.

For example, if a stock had a high of $21.95, a low of $20.22, and closed yesterday at $21.51, the true range would be $1.73.

Once you have 14 true range values, sum them and divide by 14 to get the ATR.
If you already have an ATR, use the formula:

Previous ATR(n−1)+TRn\frac{\text{Previous ATR}(n-1) + TR}{n}nPrevious ATR(n−1)+TR​

This method simplifies the calculation because you only need to calculate the TR for the most recent day.

What Does the ATR Tell You?

The ATR was initially developed for the commodities market but is also used in stocks and indices.

It indicates how much an asset’s price moves on average over a set period.

An asset with high volatility will have a higher ATR, while one with low volatility will have a lower ATR.

ATR is useful for traders to assess market volatility and decide when to enter or exit trades.

ATR does not indicate the direction of price movement but helps measure volatility, which can assist in setting stops or exit points.

A popular use of the ATR is the “chandelier exit,” which uses ATR to set a trailing stop-loss point below the highest high since entering a trade.

Example of How to Use the ATR

Suppose a five-day ATR is calculated at 1.41, and the true range on the sixth day is 1.09.

The next ATR value is calculated by multiplying the previous ATR by the number of days less one, adding the true range, and dividing by the time frame.

The ATR formula could then be repeated for subsequent periods to track volatility.

While ATR doesn’t indicate the direction of price breakouts, it can be useful for identifying when significant price changes occur.

Limitations of the ATR

ATR is subjective and doesn’t provide a clear buy or sell signal.

It only measures volatility and does not indicate price direction.

Traders may misinterpret high volatility as confirmation of a trend when it may simply reflect temporary fluctuations.

Concluding Thoughts

The average true range (ATR) is a valuable tool for assessing price volatility.

While it does not signal trends, it helps traders evaluate market conditions by providing insight into how much an asset’s price moves.

Its usefulness extends across various markets, including stocks and commodities, providing essential information for determining potential trade entry or exit points based on volatility.

Bollinger Bands have gained widespread recognition for their ability to incorporate volatility and capture price action, making them a popular tool among Forex traders.

However, several lesser-known technical indicators, such as Donchian channels, Keltner channels, and STARC bands, also offer valuable opportunities for identifying swing action and profitable trades.

These indicators are widely used in the futures and options markets and are well-suited for the vast liquidity and technical nature of the Forex market.

• Donchian channels use a moving average to signal uptrends on upper band breaks and downtrends on lower band breaks.
• Keltner channels rely on the average true range (ATR) or volatility, with breaks above or below the bands indicating potential continuation.
• STARC bands determine high-probability trades: breaking the upper band signals a lower-risk sell, while touching the lower band presents a lower-risk buy opportunity.

Although these band indicators vary in calculation and interpretation, each provides unique insights into price action.

Below is a breakdown of how each of these indicators works and how traders can apply them in the Forex market.

Donchian Channels

Donchian channels are price channel studies available in most charting platforms, useful for both novice and expert traders. Originally designed for the commodity futures market by Richard Donchian, this indicator has found broad application in Forex markets. It aims to capture profitable entries by signaling new trends when price penetrates either the upper or lower band.

Signals:

• Buy (Long): When price breaks above the upper band.
• Sell (Short): When price breaks below the lower band.

Rather than signaling reversals, Donchian channels help identify when a new trend may be emerging.

For instance, if price action surpasses the high range, it may indicate an uptrend. Conversely, if it drops below the low range, a downtrend might be forming.

Example: In a one-hour EUR/USD chart, we observe that price action breaks through the upper band on December 8, signaling a potential long position. A trader following this signal could have captured nearly 100 pips in a short-term intraday trade.

Keltner Channels

Keltner channels, introduced by Chester W. Keltner and later modified by Linda B. Raschke, use ATR to measure volatility and generate trade signals similar to Bollinger Bands.

However, Keltner channels rely on the high and low prices to calculate volatility rather than standard deviation.

Signals:

• Buy (Long): When price breaks above the upper band.
• Sell (Short): When price breaks below the lower band.

These channels favor a continuation of the price movement after breaking the bands rather than expecting a reversal back to the median.

Example: In a daily GBP/JPY chart, the price action breaks above the upper band, signaling the trader to enter a long position.

This setup offers multiple opportunities to capture profitable swings, including a 300-pip gain after the initial breakout.

STARC Bands

STARC bands (Stoller Average Range Channels), developed by Manning Stoller, incorporate volatility into their calculations, similar to Bollinger Bands.

However, they focus on identifying higher-probability trades by highlighting lower-risk sell and buy opportunities.

Signals:

• Sell (High-Risk): When price reaches the upper band.
• Buy (Low-Risk): When price touches the lower band.

STARC bands are particularly useful in helping traders identify lower-risk entry points. When paired with disciplined money management, this indicator can minimize losses while maximizing gains.

Example: In a NZD/USD chart, price action reaches the upper band, signaling a low-risk sell opportunity. Confirming this with a Stochastic oscillator, the trader could capture a 150-pip profit as the currency pair retraces.

Putting It All Together

Combining band-based indicators such as Donchian channels, Keltner channels, and STARC bands provides a diverse approach to identifying profitable opportunities in the Forex market.

Concluding Thoughts

While Bollinger Bands are widely recognized, lesser-known band indicators like Donchian channels, Keltner channels, and STARC bands offer unique and equally profitable opportunities.

By understanding and incorporating these alternative tools, both novice and experienced traders can diversify their strategies and enhance their ability to capture opportunities in the Forex market.