Financial instruments have personalities. Not in the sense that they are humble or funny, but rather the way they move. ATR or average true range tells traders what to expect when trading these instruments. Consider it a rap sheet for the instruments recent behavior.
ATR stands for Average True Range, or Average Trading Range. Traders consider this a volatility measure. A volatile stock or commodity has a high ATR, a less volatile name has lower ATR. Additionally, this measure helps traders define risk and future expectations about the stock or commodity. The calculation is simply the absolute value of the current high minus the current low. Also, it is a moving average of values, normally kept during a 14 day period.
ATR In Practice
By definition, lower priced names have lower ATRs, and visa versa. This is why technical traders frequently plot the study under price charts. Furthermore, this study helps traders identify when stocks are most volatile relative to their past. It does not matter that a $4 stock has an ATR of .20. It matters only that the ATR a week ago was .10, for example. Traders use this information in combination with price when making trade decisions.
Additionally, stocks or commodities typically put in the largest ranges at the end of a move. Taking a long example, this makes sense because the action consists of the last buyers rushing to enter and the last shorts panicking to cover. In this way, the measure tells traders when to exit a winning position, or at least hesitate to initiate new positions.
Most noteworthy, ATR does not measure direction like other momentum indicators. Rather, it measure the level of participation of other players. This is paramount for traders because risk management is a best practice. A trader who does not understand ATR and how it affects their positions may end up risking more than originally anticipated. Over time, this mistake causes traders a massive reduction in capital, thus forcing them out of the business.