The average true range is a process that is used to measure volatility as it relates to the performance of a given stock within a particular market. This approach was first introduced in the book New Concepts in Technical Trading Systems, written by Welles Wilder. Originally developed with commodities in mind, the strategy is often used to evaluate stocks and stock indexes.
With an average true range, the approach involves the consideration of the stock movement over a period of two weeks, identifying the highest unit price reached during that time, as well as the lowest. At the same time, the investor will consider the current day’s highs and lows. The idea behind this approach is that identifying the price range that occurs during the period under consideration provides excellent indications of how others are responding to the stock offering. If the range is higher, this indicates the risk or volatility is higher. In situations where the range is somewhat lower, an investor encounters less risk by either acquiring shares of the stock, or holding on to any shares he or she already owns.
Proponents of the average true range note that the data can be very helpful in plotting investment trades, and gaining a more attractive position for the portfolio overall. Since the process looks closely at recent historical data as well as data related to the most recent period, identifying the average true range presents a fairly reliable projection of what is to come. Assuming that projection is correct, the investor who makes use of this approach stands to earn a higher return for his or her efforts. At the very least, employing this approach can position the investor to minimize losses that are likely to take place, based on what happens in the marketplace in the next upcoming period.
Detractors of the average true range do not deny that the approach has value, and does yield information that is helpful in making investment decisions. The main argument against relying solely on this strategy is that it does not allow much room for events that have not occurred in the recent past, but could occur within the near future. From this perspective, the recommendation is usually to make use of the results of an average true range calculation, but to also take into consideration any known factors, such as the outcome of a political election, that could influence the movement of the stock in short order. Doing so is thought to protect the interests of the investor to a greater degree than relying on the results of the true range calculation alone.
