i. ATR stands for Average True Range. It is a volatility indicator.
ii. Can be used to take entries, set stop loss, and also for exiting trades.
What is the Average True Range?
The Average True Range or ATR is a technical indicator developed by the renowned technical analyst J. Welles Wilder back in the 1970s.
The ATR is a volatility indicator that traders can use to create a holistic trading system.
Volatility is as important as the directional movement of price. If you get the direction right, you can make profits. If you get the timing right for volatility, you can make even bigger profits.
Volatility indicates how much price can move potentially. Imagine if you can gauge this volatility, it can do wonders if used right.
The Average True Range is basically a set of calculations on past price movements and it produces a smoothened value of the price volatility at the point of time.
The ATR indicator has many uses and I will dive into it further in this blog post. Read ahead to understand how it works and how you should use this indicator.
How does ATR work?
There is a proper calculation behind the ATR indicator and in order to do so, the true range is calculated first.
Depending on how the price moved, the true range is calculated in three ways:
i. Current high - Previous close
ii. Current low - Previous close
iii. Current high - Current low
For any particular trading period, the greatest value from the above-mentioned calculation is considered.
These values are obtained and the calculation is smoothened out and an average is taken.
There is an additional calculation involved but we will not dive into it as a trader need not really know the math technical stuff.
Whenever you apply the ATR indicator to any price chart, you have to specify a time period for the indicator. The default value is 14, but you can always test different values.
The ATR indicator can be applied to all time frames and the indicator will give an output of the Average True Range of the past price movement in that time period.
The main input in the ATR indicator is the price movement.
When you apply the indicator on a price chart, you will see that whenever a wide candlestick is formed, ATR values are high. When candlesticks are small, ATR values are low.
Hence, the range of the candlesticks is directly proportional to the value of the ATR.
The ATR values are displayed below or above the price chart and it has a scale of its own.
What difference does the ATR make?
The main purpose of the ATR indicator is to help traders understand the volatility.
Volatility will tell the trader about the strength in the market and traders can know how much the price can move in either direction.
It should be noted that the ATR indicator does not say anything about the direction of the market. But rather it allows traders to know how fast the price can move in case it chooses any particular direction.
The market does not always move with high volatility but rather it moves in volatility phases. Price will move between the low volatility phase and high volatility phase.
It is often noticed that when the price is in a range, volatility is low and whenever a breakout takes place, volatility shoots up. This is where the ATR indicator makes a difference.
In trading, you don’t just have to get the price direction right but you also have to get the timing right.
For instance, you are bullish on a particular currency pair but you take a long position very late into the move and you almost bought at the top.
After buying, the price tanked. Your initial bias was right but it is possible that you were late in your analysis or were late in your execution.
This is where the ATR indicator can help you out. Read further to know how you can use this indicator to make the best out of every situation.
How can you use the ATR indicator?
1. Finding trade opportunities
I already mentioned that the ATR indicator is not a trending indicator and does not indicate the direction of a trend.
What it simply does is tell the trader whether the volatility is high enough to put the price in a trending phase.
So what you should do here is to find a currency pair that is trading with a low ATR value. This indicates that volatility is low.
When volatility is low, the price usually consolidates and moves in a range.
You should wait for a price breakout from the range and it should be supported with an increase in volatility.
Another way to use ATR is to couple it with another form of analysis and use this indicator as a confirmation signal.
For instance, you have a particular strategy for a currency pair and it gives a buy signal during the trading session.
What you can do here is that you can check the ATR value for volatility.
If your strategy can perform in high or low volatility then take the trade, if not then do not take the trade.
Some strategies require high volatility while some require low volatility.
You can use the ATR indicator to gauge the conditions and then act accordingly.
2. Setting stop loss
Stop loss is very essential in trading as it allows you to cap your loss.
What traders normally do is, have their stop loss based on price levels. Using the ATR indicator in this case, you can place your stop loss based on volatility.
For instance, you identify a short setup on a currency pair and decide to trade it. You take an entry, set your stop loss, and take profit orders. Your stop loss gets hit. Sucks right?
What you should have done was to check whether the stop loss was placed far enough from the entry-level as the ATR value.
If the ATR value is 50 pips and you place your stop loss 40 pips away, then there are high chances that your stop loss will be hit.
Placing your stop loss more than the ATR value will ensure that you survive that volatility condition.
Some traders multiply the ATR value by 1.5 and then place the stop loss while some double the ATR value and then place it as stop loss.
You can choose how far you want to place the stop loss but it should be noted that stop loss should not be placed so far away that it messes up the risk to reward ratio.
3. Setting take profit levels
Let’s suppose you trade a currency pair that has an ATR value of 100 pips.
You identify a trade setup for a long position and it checks out everything and you decide to take the trade.
As per the setup, your take profit should be 60 pips. But the price has already moved 50 pips before your trade.
In this case, for your trade to be successful, you need the price to move a total of 110 pips i.e. 60 pips more from the already 50 pips move.
This is higher than the ATR value and there is a high chance that your take profit level will not be reached.
Instead of taking the trade only to see that it reverses after getting so close, you can shift your take profit level according to the ATR value. In this case, your take profit will be 50 pips instead of 60 pips.
Yes, it will reduce your risk to reward ratio, but it will increase the probability of the trade ending in your favor.
These were some ways that you can trade the Average True Range indicator.
It should be noted that the ATR indicator should not be used standalone. You should use this indicator as a supplement to another indicator or use it in a strategy you already trade.
The ATR indicator has vast benefits which we have already discussed and it is due to this reason that even the most advanced traders look to incorporate this indicator in their trading.
What are your thoughts on this indicator?
Do you use the ATR indicator or are you planning on giving it a try? Do let me know about your experience with this amazing indicator.
Share this blog post with every trader you know and let them also explore this indicator and make complete use of it.
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