The Average True Range indicator is a technical analysis tool that measures the variability, fickleness, and volatility of market price movements. It evaluates how much price moves in specific periods over a total number of periods and determines the level of price fluctuation of an instrument in the market.
- The Average True Range (ATR) is an indicator traders use to gauge the market’s volatility.
- The technical analysis indicator does not provide information on the direction of price action. Instead, it is a good indicator that can be incorporated into a trading strategy for setting stop loss and determining position size.
- Traders can apply the ATR to various timeframes and trading instruments.
- Traders use ATR to assess potential risks and market conditions.
This article explores the Average True Range indicator, how it works, and various strategies to use it in your trading endeavors. We also highlight the benefits and limitations derived from the indicator. Now let’s get right to it.
What is the Average True Range (ATR) Indicator?
Developed by J. Welles Wilder Jr. and introduced in his book “New Concepts in Technical Trading Systems,” the ATR measures price volatility by breaking down the total range/volatility of price movements for a given number of periods.
Technically, the Average True Range (ATR) indicator is a technical analysis tool that differs significantly in functionality compared to many others. While many indicators analyze the direction and volume of price action, the ATR evaluates the volatility. It is, therefore, among the most popular indicators, especially for day traders, and those looking to trade options trading strategies.
On a price chart, the ATR is displayed as a sub-chart below the main chart:
Indeed, observing how much the price moves is possible by merely looking at the chart. However, there are instances where a trader requires the quantitative and actual values of these fluctuations in the market for further decision-making, and the ATR comes in here.
Note that the ATR does not provide buy and sell signals directly. As such, the ATR should be used in conjunction with other technical analysis tools to determine entry and exit levels. Still, the measurement of volatility obtained by the indicator provides a different perspective on market dynamics that could significantly enhance your trading decisions.
How Does the Average True Range (ATR) Indicator Work?
To understand how the Average True Range indicator works, let us closely examine the formula that forms the indicator. First, determine the number of periods to evaluate. By default, this is 14 periods. The ATR calculation for this number of periods is thereby given as
TRi = Specific Period’s True Range.
n = Number of periods.
The indicator uses the formula above to evaluate the first ATR for the considered asset. It uses a different and less complex formula for subsequent periods as follows.
n = Number of Periods
TR = True Range
The True Range (TR) is the most significant value of any of the following three evaluations;
High minus Low. This measures the range between the highest and lowest prices in a period. (H-L)
High minus the previous close. This captures the difference between the current period’s highest price and the last period’s closing price. (H-Cp)
Low minus the last close. This reflects the price gap from the previous close to the current low (L-Cp).
After every evaluation, the ATR is displayed as a line chart that rises and falls as volatility increases and decreases. By implication, a high-value ATR means price fluctuations are high and rapid. Conversely, a low-value ATR implies a relatively stable price movement, mainly observed when the market consolidates.
Take note that a rising ATR does not suggest price is trending upwards. ATR can rise on the chart when price action dumps, hence, the market is trending down. This means that the ATR strictly measures market volatility, not trend direction.
How to Use The Average True Range Indicator in Trading
The ATR technical analysis indicator is primarily used for applying risk management to your trades. It is also useful for determining position sizes for trade entries. This section examines two significant ways to apply ATR to your trading strategy.
Firstly, the ATR is very applicable for setting stop-loss levels. The idea is to use a certain ATR level, or a multiple of it as your stop loss. You can also do the same for your take profit. So, if you have a current ATR reading of 100 on the EURUSD, you can use this value to set your stop loss 100 pips away from your entry and your take profit will be 150 pips (1.5ATR) or 200 pips (2ATR) away from your entry.
Bear in mind that the most important factor in using the ATR indicator is the value presented by the indicator and not the ATR line movement. This value shows the average pips on the market you trade on over the last 14 candles (if that’s your default setting). So, the higher the value, the more volatile the market, and vice versa.
Another way to apply the ATR is to determine the appropriate position size for your trade. Since the ATR helps you understand the volatility levels in the market, it can help you determine how much capital you should invest in your trade by considering the ATR value and your risk tolerance level.
For instance, if you are trading a very volatile instrument indicated by a huge ATR value, reduce the amount you invest to avoid excessive losses. Otherwise, you may wish to increase your trading position size if the ATR value is small.
Average True Range Indicator Trading Strategy Tutorial
Now, let’s close in on a step-by-step procedure for trading financial assets with the Average True Range indicator. In this example, we look at the application of the ATR indicator in a breakout strategy. After that, we use the same ATR as a trade management system to trail our stop loss and place take-profit orders for as long as the trade allows.
Trade Management With ATR
One of the things that this technical indicator excels at is being used to gauge trade management, meaning setting stop loss and take profit levels. And the process is simple.
When using the ATR, you determine your trade entry using any other indicator or technical analysis tool at your disposal. But when you want to set your stop loss, you pull out your ATR and note its value at the time of your entry.
In the EUR/GBP chart below, for instance, we use two EMAs (Exponential Moving Averages) with periods 21 and 9 to generate our trading signals. Once the EMAs give us a bullish signal, we take note of the current ATR value. Remember, the ATR indicator measures the volatility in pips when trading forex and in any other unit of change for other instruments. In our example, when entering the trade, the ATR shows 78 points or 7.8 pips.
However, because the price has been somewhat volatile recently, judging by the three strong bullish candlesticks before the formation of the EMA signal, we might need to set our stop loss a little far away from the entry.
As a result, we chose 2ATR as our stop loss, which is 15.6pips away from the entry. And, if using a standard risk-reward ratio of 1:2, then our take profit can be double that, at 31.2 pips away from the entry.
Note that there is no mechanical way to know what multiple of the ATR to use, as this would depend on the trading strategy being traded. However, with constant backtesting and the use of your trading strategy, you’ll find what works for you.
To sum up, the chart below is what your trade would look like using the ATR indicator, with stop loss and take profit target.
Average True Range (ATR) Indicator – Pros and Cons
The Average True Range indicator is one of the few indicators that give insight into the volatility of price action in the market. It provides a quantitative evaluation of price fluctuations that help traders determine stop loss, trade risks, and sometimes trade entries. Yet, it has limitations you need to keep in mind when using it. We discuss some benefits and limitations of the ATR below.
Benefits of Using the Average True Range Indicator
Clearly, determining the price volatility of an instrument helps to understand better and predict future price fluctuations.
This is especially useful when managing stop loss and trading risks. And that’s the main benefit of using the ATR. Unlike other indicators, the ATR serves a good purpose for managing trade risk management. Some benefits of the ATR are highlighted below.
- The ATR helps traders gauge market volatility
- It is helpful for setting stop loss levels and position sizing
- It can also easily be used on various timeframes and trading instruments
- The ATR provides a quantitative measure of risk
Limitations of the Average True Range Indicator
The ATR exhibits certain limitations that make it imperative to only consider it as a component of a wholesome strategy rather than a stand-alone indicator. Some of these limitations are highlighted below.
- The ATR does not provide information on the direction of price movement
- It may also not be effective in a low volatility market such as a ranging, consolidating market
- Like any other indicator, the ATR is not foolproof and should be used with other analysis tools
- The ATR indicator is a valuable tool for traders seeking to assess market volatility and manage trading risks.
- Since the ATR helps you to get an insight on market volatility, incorporating the ATR indicator into your technical trading systems helps you make more informed decisions about stop-loss levels, position sizing, and trade entries and exits.
- Typically, the ATR is not used as an indicator that generates trading signals; instead, it is mostly used to get a comprehensive understanding of market dynamics and to develop a trade risk management system.
Frequently Asked Questions About Trading the ATR Indicator
The following are some of the most frequently asked questions about the Average True Range Indicator.
How do you use the ATR indicator?
You can use the ATR to measure and manage volatility in many ways, but primarily for setting stop-loss orders, determining position sizes, identifying trend reversals, and establishing entry and exit points in your trading strategy. For instance, if your ATR is high, you might either loosen your stop loss while trailing stop to avoid being kicked out abruptly from a trend or tighten the stop loss to protect your investment from wild price swings.
What does the ATR tell you?
The ATR provides information about a financial instrument’s average daily price movements over a specified period. It is a volatility compass that shows you price action differentials that occur averagely for a trading instrument and enables you to factor these radical or moderate price movements into your trading decisions.
What is the difference between ATR and ADR indicators?
The ATR measures price volatility by evaluating the average daily price range. In contrast, the ADR (Average Daily Range) provides the average range between the daily high and low prices over a defined period. While they both offer insights into price movements, the ATR focuses on volatility, while the ADR gives a historical range without considering volatility. Traders primarily use the ATR for risk management and strategy adjustments, while ADR can help set profit targets and gauge overall price movements.