The Average True Range (ATR) is a volatility indicator developed by J Welles Wilder in his book "New Concepts in Technical Trading Systems". The true range is calculated as the greatest of the following three calculated differences: (1) The current high less the current low, (2) the absolute value of the current high less the previous close, and (3) the absolute value of the current low less the previous close. The average true range is calculated as a moving average of the individual true ranges and is generally calculated over a span of 14 periods.
The whole purpose of determining the ATR is to try to understand the average amount of variability is to be expected during an individual period. For instance, if the ATR for a particular stock that is priced at $20 is $4, then the average range of that stock would be between $18 and $22. There are a lot of uses for this type of information. If a stock is stuck within a trading range for an extended period of time the ATR will generally decrease in value. If a stock begins to break out of a sideways movement either to the upside or downside the ATR will begin to increase (it's an absolute number and therefore does not determine direction). This increase in the ATR can signal a breakout for a stock.
The ATR can also be used to determine position size when buying into a new stock. As we've discussed in other articles, any time I begin buying a stock to create an equity position in my portfolio, I am risking my hard earned money. I always try to control the amount of risk I am willing to assume which I feel is prudent for my portfolio. As an example, suppose I have a portfolio worth $10,000. I hate to risk more than 5% of my portfolio on any individual investment. For me that means $500. If I'm looking at a stock priced at $20 and the ATR is $4 (as in the example above) then there's a possibility that the stock will waiver between $18 and $22, on average, during whatever period I'm tracking. In essence there's a pretty good possibility that I could lose $2 per share ($20-$18 = $2). Knowing that and the fact that the most I'm willing to lose on any one trade is the $500 identified above, I'm willing to buy 250 shares of stock of the company I'm interested in. This limits my risk and limits the amount of drawdown of my account to the amount determined before I enter the trade.
My personal preference for using the ATR is the weekly ATR. As mentioned before I am not a day trader and by using the weekly version of this indicator I'm using a greater ATR and hence this reduces my position size and allows me more maneuver room before I have to close out a position. This limits my downside by simultaneously limiting my upside but if the stock starts acting correctly I can always increase my holdings as the stock moves up. This way I am actually following a developing trend and increasing my likelihood of success.
J Welles Wilder developed a number of technical indicators in his book "New Concepts in Technical Trading Systems" to include the Parabolic SAR, the RSI and the Directional Movement Concept (ADX). Each of these were developed and used by Mr Wilder long before the computer age but even with all of today's computing power these indicators still hold up their effectiveness.