The Average True Range (ATR) indicator measures a security's volatility
over a given period. As such, the indicator does not provide an indication of price
direction or duration, only the degree of price fluctuation.
More specifically, the ATR is the (moving) average of the True Range (TR)
for a given period. The TR 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.
Hence, the ATR for some period N is the sum of
all the TRs over this period divided by N. Typically,
N is taken to be 14 days, but within the Bourse, you can specify the period of your
choice.
An assessment of the prevailing market volatility must accompany the deployment
of any trading strategy. If market volatility is high, stops will need to be placed
further from the market in order to avoid whipsaws (when a market moves so that
one is stopped out and then turns in the direction of the original signal). If volatility
is low, indicators may generate a number of false signals whilst the market is directionless.
Most technical strategies work best in markets of medium volatility.
High volatility is often experienced at the end of a trend, and is said to be an
indication the trend is about to reverse. Volatility is also a key component in
options pricing. When volatility is high, options become more expensive, and when
volatility is low, option premiums become cheaper.