This Time-Tested Volatility Indicator Helps Traders Avoid False Breakouts

There are a number of ways to measure volatility. Average True Range (ATR) one of the older measures used by traders that have stood the test of time.

ATR was introduced to the trading community by J. Welles Wilder in his 1978 book, New Concepts in Technical Trading Systems. Mathematically, the formula is similar to an exponential moving average and was relatively easy to calculate before computers were available.

The first step in calculating the ATR is to find the true range, which is defined as the largest absolute value of the:

1. High – Low,
2. High – Previous Close, or
3. Low – Previous Close

Although the true range or ATR can be calculated for any time frame, we will use daily data as an example. Since the ATR is designed to measure volatility, the true range will look back to the previous day to measure the range when a gap or inside day occurs in the market.

A gap is a day when the market opens above the previous day’s high or below the previous day’s low. The true range accounts for the gap in the volatility, while simply measuring the distance between the high and low would miss the size of the actual daily price move.

An inside day is a day with a small difference between the high and the low, and by looking back to the previous day’s close a better view of trading activity and volatility can be obtained.

The true range is calculated each day, and ATR is commonly found using 14 days:

Current ATR = [(Yesterday’s ATR * 13) + (Today’s True Range)] / 14

How Traders Use ATR

Traders can use ATR to confirm a price breakout. Breakout moves are likely to be accompanied by an increase in ATR. Trading ranges will generally be consistent with lower values of the ATR.

In the chart below, the ATR is applied to the Dow Jones Industrial Average using monthly data. A moving average has been added in order to highlight trend changes.

Note the times when the ATR crossed above the moving average and then fell back below the average. This means price volatility was much higher during the time when the ATR was above its moving average.

The drastic move in ATR above the moving average during March of 2020 could have helped investors steer clear of the market, avoiding much of the panic-driven selloff. On the other hand, traders often like volatile markets since larger price moves allow them to make greater profits and may decide to trade only in markets where the ATR is above average.

Traders can also use the slope of the ATR line to assess whether the indicator is rising or falling. They may want to participate in markets where ATR is rising hoping that they will catch the fastest moving trends. This technique will be more sensitive than applying a moving average to the indicator and should lead to more trading signals.

Why It Matters To Traders

Price charts often show a false breakout. Price consolidations will generally take place while the value of ATR is low. False breakouts occur when price makes a small move out of the consolidation pattern and then falls back into the trading range.

Sustained breakouts will often be accompanied by a rising ATR, and trading only when ATR confirms the price action should help reduce the number of losing trades.

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