I was having this conversation with a coachee of mine, who was bent on using ATR instead of ADR as a reference for trading and I had to help him understand the difference and the context as to what is relevant where, and why I lean towards ADR. Below is an excerpt of what I told him.
The case for ADR
First things first - What is ADR - ADR is simply the average of intraday (High-Low) value. This excludes Gaps.
So - What is ATR? - Here is a better explanation. Essentially ATR is a range calculation which includes Gaps as it calculates from PDC (Previous Day Close).
So it essentially boils down to the significance of Gaps.
Let’s digress a bit to understand why do we use Range as a reference.
To me Range is a good indication (of / or a proxy for) volatility. You will see that for yourself, if you follow VIX, as VIX increases, so does range (Ref. the plot below). By including Gap in the calculation we may get an incorrect and irrelevant view of the intraday volatility.
As an Intraday trader I am concerned only about what happens between the Open and Close. That is what is my playing field. I am not a positional trader to take advantage of or get affected by Gaps.
So the next question to ask is? Is there a correlation between the size of the gap and the ADR for the day? This would determine if including GAP data helps us in any way.
I did a quick math by calculating the Correlation Coefficient with Gap size as an independent variable and (ADR) Range as a dependent variable and I get a score of 0.36. Take a look at the scatter-plot below.
As you can see there is no linearity in there.
So given that there seems to be no correlation between Gaps and ADR, I would recommend using ADR and not ATR,
ATR is relevant in markets or products were Gaps have a correlation with Range, which does not seem to be the case with NIFTY.
However, I do keep an eye on the Gaps, but that is more from a perspective of understanding if there is a visible change in the market structure, more on it later.
Here is a snapshot of the data that I reference during the day. It gives me a clear sense of the developing range with references of Previous day and a 20 day Look back period.
