True Range

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Introduction

In his classic trading book “New Concepts in Technical Trading Systems” Wells Wilder believed that most trading systems were broken down into two basic components, the first part focusing on the “technical trading system” and the second part on money management or in his words “capital management technique”. For the majority of these systems, Wilder believed that they all had one vital missing component which was that they did not tell traders “what and when” they should trade. Not surprisingly, the answer to the first part of this issue, Wilder believed traders should focus on trading on trending markets. What Wilder did do that was unique to his time, was that he developed trading methods that helped traders to identify if and how strong a market was trending or not trending by using his Directional Indicator or Average True Range (ATR) indicator. Let’s take a closer look at the ATR and see how it can help you improve your trading decisions.

Calculation

Wilder defined volatility as the maximum range that the price moved. He described the price movement as the true range. True range is calculated either during the day or from prior days close to the extreme point reached during the day. Wilder defined true range as the greatest of the following:

  1. The distance from today’s high to today’s low.
  2. The distance from yesterday’s close to today’s high, or
  3. The distance from yesterday’s close to today’s low.
  4. The range of a day's trading is simply high − low.

In order to account for limit up or limit down downs associated with commodities, the true range formula extends its calculation to include the prior day’s closing price if it was outside of today's range. By making this adjustment any gaps in price would also be accounted for in the ATR formula. Wilder felt that the true range needed to be an average figure if one wanted the ATR to be more meaningful indication of volatility. Many traders typically use 14 or 7 periods to calculate true range.

In Wilder’s original Volatility system, he used 7 periods in his calculation. Keep in mind that as with most indicators you’re encouraged to test which period works best to fit your style of trading.

It’s important to note that the true range formula calculates an absolute change in price, so that the true range reflects absolute changes in volatility and not a stock’s exponential change. This basically means that lower price stocks will have lower absolute changes in true range versus absolute change in higher priced stocks.

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Interpretation

As mentioned before the true range is an absolute number and it’s more important to know what level the reading was in previous period as opposed to the actual reading. Long term low readings of true range tell us that a stock was range bound. An increasing true range alerts traders that a stock’s trading activity is increasing and becoming more volatile.

As with most volatility breakout systems, Average True is based on the premise that if a stock moves a certain percentage from a current price level (a breakout), the odds favour a continuation in the direction of the move. This can also be interpreted as the beginning of a new trend.

Conclusion

In order to utilize ATR in the most efficient way, the first thing a trader needs to understand is what the average true range indicator is and what the ATR is not. First of all the ATR is not a directional indicator like the –DI and +DI indicator. Secondly, that the ATR strength is in identifying if a breakout in a stock is generating any real interest or not. Wilder believed that strong moves in stock could be spotted increases in volatility. Like many volatility breakout strategies, the key was to spot increasing trading ranges that typical begin at the beginning of a new trend. False breakouts would be usually followed with relatively narrow ranges. Traders using the ATR indicator can it as a tool confirm if there is real interest in stock’s current directional movement. Bullish breakouts or moves should be accompanied with an increase in ATR and bearish breakdowns or moves with an increase in ATR.