The task of the Average True Range (ATR) indicator is to gauge volatility over a certain period of time. Keltner Channels and Starc Bands are examples of other systems for trading in which ATR is also used.
ATR was devised by Welles Wilder and presented for the first time in “New Concepts in Technical Trading Systems”, a book he published in 1978. It is used to determine volatility and computed as the rolling average, over a certain period of time, of a true price range.
To be more precise, ATR is the moving, or rolling, average of usually a fourteen-day period of the true range. ATR is an indicator that is obtained by determining the biggest variation between: (i) the present high and the present low, (ii) the present high and the preceding close, and (iii) the present low and the preceding close.
When determining the true range, account should be taken only of positive numbers, since, as a rule, true range cannot be a negative number.
High values normally signify a greater possibility of a change in trend, i.e. greater volatility, when the market is at the stage of “blowing off”. This is due to the fact that investors turn increasingly impatient to reap financial gains. On the other hand, when the value of the indicator is low, the trend is steadier and, hence, volatility is lower, since nobody is expecting to earn fast financial gains.
Hence, to sum up, when the indicator shows high values, volatility is stronger because prices go down as a result of selling. In contrast, low indicator values mean reduced volatility, since prices become more stable or shift to a sideways trend channel before a probable burst.
When interpreting the ATR, you should employ the Accumulative Swing Index together with the Swing Index, as the latter will not suffice on its own.