True Range (TR) is a technical analysis indicator that measures market volatility by examining the range of price movement for a given period. The concept was introduced by J. Welles Wilder Jr. and is typically used as a foundational component in other volatility metrics such as the Average True Range (ATR).
Definition and Formula
The True Range of a trading period is defined as the greatest of the following three values:
Where:
- High: The highest price during the trading period.
- Low: The lowest price during the trading period.
- Previous Close: The closing price of the previous trading period.
By considering these three values, True Range accounts for potential gaps and overnight volatility that may not be captured by the day’s range alone.
Calculating True Range
- Daily Range: Calculate the difference between the current period’s high and low prices.
- Previous Close Comparison: Calculate the absolute differences between the current period’s high and the previous close, and between the current period’s low and the previous close.
- Maximum Value: The True Range for the period is the maximum of these three calculated differences.
Special Considerations
- Market Phase: The True Range can vary significantly depending on whether the market is in a trending or ranging phase.
- Gaps: By including the previous closing price, True Range accounts for price gaps between trading periods.
- Volatility Indicator: Traders often use TR within the context of the ATR to smooth out the daily variations and get a clearer picture of volatility trends.
Applicability in Financial Analysis
True Range is particularly valuable in the following contexts:
- Risk Management: Understanding price volatility helps in setting appropriate stop-loss levels.
- Entry/Exit Strategies: High TR values might indicate potential breakouts, while low TR values could suggest consolidation.
- Volatility Assessment: Comparing TR across different assets or time frames can provide insights into relative volatility.
Historical Context
J. Welles Wilder Jr. introduced the concept of True Range in his 1978 book “New Concepts in Technical Trading Systems.” Wilder’s work has since become foundational in the field of technical analysis, influencing the development of numerous volatility and momentum indicators.
Examples
Example 1: Calculating TR for a Trading Day
Given the following data for a single trading day:
Calculate the three components:
- High - Low: \(105 - 98 = 7\)
- |High - Previous Close|: \(|105 - 100| = 5\)
- |Low - Previous Close|: \(|98 - 100| = 2\)
The True Range is the maximum value: \( \max(7, 5, 2) = 7 \).
Example 2: Using TR in a Trading Strategy
A trader notices that a stock has a high True Range over the past few days. This suggests heightened volatility; the trader may choose to implement a breakout strategy, placing orders above recent highs and below recent lows to capture potential large price moves.
Related Terms
- Average True Range (ATR): A moving average of the True Range values, providing a smoothed measure of market volatility.
- Volatility: A statistical measure of the dispersion of returns, often quantified by metrics like TR.
- Range: The difference between the high and low prices in a given period, not accounting for gaps.
FAQs
What is the difference between True Range and Average True Range (ATR)?
True Range measures the volatility for a single trading period, while Average True Range (ATR) is an average of the True Range values, typically over a default period of 14 days.
How does True Range account for price gaps?
True Range includes the absolute differences between the current period’s high and the previous close, and the current period’s low and the previous close, thus capturing overnight price gaps.
Is True Range suitable for all types of assets?
While True Range is widely applicable, its effectiveness may vary based on the asset’s trading patterns and the nature of the market.
Can True Range indicate market direction?
True Range primarily measures volatility and does not inherently indicate market direction. However, traders often consider it alongside other indicators to make informed decisions.
References
- Wilder, J. Welles, Jr. “New Concepts in Technical Trading Systems.” Trend Research, 1978.
- Murphy, John J. “Technical Analysis of the Financial Markets.” New York Institute of Finance, 1999.
Summary
True Range (TR) is a crucial measure in technical analysis, used for assessing market volatility by examining the range of price movement in a given period. As a foundational component introduced by J. Welles Wilder Jr., it serves as a versatile tool in risk management, strategy formulation, and volatility assessment within financial markets.
