What is the Average True Range? Obviously it is the average of the true range measurement so the first question has to be what is the true range measuring? It is measuring volatility as expressed by the maximum range of price over two days. Hunh?
The true range is finding the lowest of either the low of this period or the close of the last period and subtracting that from whichever is higher - the high of this period or the close of the last period. Here are some diagrams of what that might look like.
And here is a display using INDU. Note in this figure that true range (tr) ‘a’ uses the close from 2/26 and the low from 2/27 and that ‘b’ uses the high and low from a single day. Note that the Average True Range is an exponential average.
So, why is the ATR important to traders? Because as is pointed out in this Wikipedia article the ATR measures volatility. And volatility is a "tell" regarding future market direction.
I noticed some time ago that when the ATR on the Dow Industrial average dipped below 80 the market was due for a decline - not immediately but within a couple of days. That would be followed by an ATR spike when the market started going down and then the market would resume going up once the spike was done and had rolled over and went back down again. You have to understand it isn’t that the ATR is doing anything, it is the Industrial’s price that is doing all of the work. The range from period to period or within the period is what constitutes the true range – the ATR just makes price volatility that much more visible. One thing I do want to point out though - the '80' figure that I used above will not necessarily hold for all market periods - you have to be observant and watch for what works or doesn't.
Here is a one-year figure showing this relationship between spike and drop and return to normal.
Here it is over two years.
And, finally, three years on a weekly basis – note that the value has changed which makes sense because this is a weekly view but that the effect remains the same. The notes on this chart are also important.
The ATR can be used on a variety of time frames but the length might need to be varied to take into consideration the time period being used. I.E. you will have to experiment to find what works for you.
And just as important is the following - This is not a correlation to the absolute. If everything were correlated to “1” there would be no room for error. Without error we could not learn. And without learning we can not grow - Marlyn Trades