What is the Average True Range?
The average true range is a price volatility indicator showing the average price variation of assets within a given time period. Investors can use the indicator to determine the best time for trading. The average true range also takes into account the gaps in the movement of price.
- The average true range is an indicator of the price volatility of assets over a specific period.
- Average true range values are generally calculated based on 14 periods. The period can be monthly, weekly, daily, or even intraday.
- A high value of average true range implies high volatility of the market price of the assets and a low value implies low price variations.
Calculating the Average True Range Indicator
The calculation of the average true range is 14-period based. The period can be intraday, daily, weekly, or monthly. For example, a new average true range is calculated every day on a daily chart and every minute on a one-minute chart. When plotted, the readings form a continuous line that shows the change in volatility over time.
For calculating the average true range, a series of true ranges needs to be calculated first. For a specific trading period, the true range is the maximum of absolute values of the following:
1. Current high – Current low
2. Current low – Previous close
3. Current high – Previous close
An average is taken for the recorded values of each period using the number of periods as 14. It gives the value of the average true range. The initial 14-period average true range value is calculated using the method explained above. For subsequent 14-period average true ranges, the following formula is used:
Current Average True Range = [Prior Average True Range * 13 + Current True Range] / 14
Interpreting the Average True Range Indicator
If the average true range is expanding, it implies increasing volatility in the market. The average true range is non-directional; hence, an expanding range can be an indication of either short sale or long buy. A sharp decline or rise results in high average true range values. The high values are generally not maintained for long.
A low value of average true range indicates small ranges in a number of consecutive periods. The low average true range values imply lower price volatility. If the average true range value remains low for some time, it may indicate the possibility of a reversal or continuation move and an area of consolidation.
The average true range – an indicator of price volatility – is used for entry or stop prompts. The average true range stop adjusts to consolidation areas or sharp price movements, triggering the unusual movement of prices in both upward and downward directions. The multiple of average true range, for example, 1.5 * average true range value, can be used to track the abnormal price movements.
Average True Range and Trading
The price volatility indicated by the average true range can be used by traders to determine the appropriateness of a trade. Suppose that the trading range for a stock is 1.40, and the stock’s moved up 40% above the average. In such a case, an investor will get a buy signal.
However, the price of the stock’s already risen above the average; hence it is not advisable to assume that the price will rise further. As the stock price is significantly higher than the average, there is a high possibility that the price will fall. Therefore, it is better to short sell provided the investment strategy of the investor shows an appropriate sell signal.
The average true range values are useful for entry and exit triggers. However, they should not depend only on the average true range, rather it should be used along with a strategy to determine suitable trades.
Moreover, an investor should also review historical readings of average true range to examine the current price movements. The value of the average true range changes and generally falls during the day. Nonetheless, it provides a satisfactory approximation of the price variations and the time that will take for the movements.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: