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The Average True Range (ATR) indicator is one which falls in the general category of volatility-based technical analysis tools. It is so because like Bollinger Bands, another volatility-based study, it does not focus on direction in any way, but rather how much raw movement there is in price. To understand this a little better, it is worth taking a look at how the indicator is calculated.

ATR Calculation

The ATR calculation starts with determining the True Range (TR). The TR for a given period is defined as being the largest of:

• Current Period High minus Current Period Low
• Current Period High minus Previous Period Close
• Previous Period Close minus Current Period Low

ATR is the average of the True Range (TR) over the past n periods. This is calculated the same as any standard simple moving average. The default setting is generally 14 periods.

As can be seen by examining the determination of TR, the study is attempting to capture the amount of actual price moment which has taken place during a trading period, which differs somewhat from the trading action. The latter could be defined as where the market actually traded during the course of a trading period, but the former actually takes in to account price gaps between periods.

It should be observed that ATR as calculated is not in any way normalized.  That is to say because it is purely a price measure, ATR cannot easily be used to compare different securities as the indicator's readings would expected to be different for instruments with different prices.  For example, one would expect ATR to be significantly higher for a stock trading at 100 than for one trading at 20. 

In order to compare ATR across securities, or even across timeframes for the same security, it would have to be normalized.  This can be accomplished by dividing the ATR by some current price measure such as the most recent close or a moving average.  That would given a reading of ATR as a percentage of whatever that standard divisor is.  So if ATR on a 100 stock is 5, then the normalized ATR would be 5% (assuming the close is used for the calculation).

We can look at the following example of the monthly S&P 500 chart which has both standard ATR (middle) and a normalized ATR plotted (lower).

(click to enlarge)

Notice how the normalized ATR flattend out in late 1998 even as standard ATR kept rising.  That is an indication that while the absolute price moves were still on the rise, on a relative basis they were not.

ATR Plotted

The graphic below depicts ATR plotted for the S&P 500 futures over a recent period. A candlestick chart has been utilized to better outline the range for each trading day. Notice how the ATR line in the middle of the graph rises when there is a preponderance of large candles as during the latter part of October, then falls when the ranges contract during the uptrend which follows.

(click to enlarge)

Take note of the fact that in the high volume period during December, ATR was falling because the price movement was limited.  That serves to underline how it is not trading activity, but rather price movement which is measured by ATR.  The two do not necessarily go hand-in-hand.