Trading Educators Blog
How does the ATR indicator work?
The ATR indicator stands for Average True Range, it was one of the handful of indicators that were developed by J. Welles Wilder, and featured in his 1978 book, New Concepts in Technical Trading Systems.
Although the book was written and published before the computer age, surprisingly it has withstood the test of time and several indicators that were featured in the book remain some of the best and most popular indicators used for short term trading to this day.
One very important thing to keep in mind about the ATR indicator is that it's not used to determine market direction in any way. The sole purpose of this indicator is to measure volatility so traders can adjust their positions, stop levels and profit targets based on increase and decrease of volatility.
The formula for the ATR is very simple: Wilder started with a concept called True Range (TR), that is defined as the greatest of the following: Method 1: Current High less the current Low Method 2: Current High less the previous Close (absolute value) Method 3: Current Low less the previous Close (absolute value) One of the reasons Wilder used one of the three formulas was to makes sure his calculations accounted for gaps.
When measuring just the difference between the high and low price, gaps are not taken into account. By using the greatest number out of the three possible calculations Wilder made sure that the calculations accounted for gaps that occur during overnight sessions.
Keep in mind, that almost all technical analysis charting software has the ATR indicator built in. Therefore, you won't have to calculate anything manually yourself. Wilder used a 14-day period to calculate volatility; the only difference I make is to use a 10-day ATR instead of the 14-day.
I find that the shorter time frame reflects better with short-term trading positions. The ATR can be used intra-day for day traders, just change the 10 day to 10 bars. The indicator will calculate volatility based on the time frame you chose.