J. Welles Wilder is one of the best known technical analysts to have written at length about volatility indicators.
His 1978 book, “New Concepts in Technical Trading” introduced a lot of fundamental concepts of modern technical analysis, and one of such is an indicator known as Average True Range (ATR).
Volatility indicators have always been deployed by professional market participants to properly determine the real volatility of the market.
The Average True Range (ATR) shows how much a currency pair moves, on an average, over a given time frame.
Day traders can deploy the ATR due to its multiple uses. Keep it in mind that the ATR indicator can’t be used to decipher market direction of any sort.
The main purpose for this indicator is to gauge volatility in order to ensure traders can modify their orders, trailing stop loss and profit levels based on surging and diminishing volatility.
Another important aspect of the ATR indicator is that it can be used on any market of choice (for example the forex market), thereby increasing your likelihood of profitability.
Fig. 1.0
The ATR indicator moves along with the price of a forex pair, as such if an FX pair’s prices become larger or smaller, it is as a result of price moving up and down respectively.
The ATR relies solely on price moves, which implies that such reading is a pips value in the forex market.
For instance, an ATR reading of 0.19 means that price has moved $0.23 on an average, per price bar.
In the currency market, the indicator denotes pips, as such a value 0.0019 depicts 19 pips.
Formula
The ATR formula is calculated in a quite simple manner. Compute the A, or the average, which first requires knowing the True Range (TR).
The TR is explained as the greatest of the following.
Current high minus the previous close.
Current low minus previous close.
Current high minus current low.
It shouldn’t be a thing of concern if the value is positive or negative. It is usually the highest possible value that is deployed in computing the formula.
The numbers are recorded each day, and then an average is recorded. If the ATR is computed over a 14 time period, we’ll get a formula that looks like this:
ATR = [(Prior ATR x 13) + Current TR] / 14
Understanding Basic Average True Range Signals
Typically, the ATR shows just about how much a currency pair moves over a given session.
Wilder initially recommended an ATR trading system that was an integral part of his trend-following volatility strategy.
The rules suggest that when you have initiated an order in line with the trend – for instance, going long on the currency pair that makes fresh highs each day.
The general rules are really simple to adhere to and efficiently spot where to stop and reverse your position.
How to profiting from the volatility cycle is a question that is always on the minds of traders.
The ATR does not necessarily say the direction the breakout will take, it can be combined to the closing price and the investor is free to take up buy positions whenever the next day’s price trades above that number.
Trading alerts on the ATR indicator are somewhat infrequent but usually pinpoint important breakout points.
The whole idea behind these alerts is whenever price closes more than an ATR above the most recent close, a volatility change has taken place.
Initiating a buy alert is insinuating the currency pair will finish off in the upward direction.
1. ATR Exit Signal
A trailing stop depicts our ATR Exit Signal. For instance, if you initiate a buy entry and price surges as anticipated.
The use of a trailing stop will get you out just in case price does not go as expected and possibly takes a dive.
In other words, this would mitigate risk or take some profit as price goes in your favor.
At the instance when the order was opened, observe the current reading of the ATR.
Enter a stop loss at a multiple of the ATR.
The common multiplier is two, which implies you can enter a stop loss at 2 x ATR below the entry price for a buy signal, or 2 x ATR above the entry price for a sell signal.
The stop loss only acts to mitigate risk or take some profit.
For long positions, if price moves in your favor, keep adjusting your stop loss to 2x ATR below the entry price.
The stop loss will only head up, not down.
Once it is taken higher, it remains there until we are able to move it higher again, or the position is closed due to price dipping to test the trailing stop loss level.
Sell orders can adopt the same procedures. The stop loss is only pointed lower.
For instance, a buy position is entered at $20 and the ATR is at 0.20.
Initiate a stop loss at 19.60. When price surges to $20.40 and the ATR stays at 0.20.
The stop can now be moved up to $20, which denotes 2 x ATR below the most recent price.
When the price drive higher to $21, the stop loss is adjusted to $20.60, taking a profit of $0.60 on the position.
Fig. 1.1
The chart in Fig. 1.1 shows marked areas on our activity chart where volatility is high, as such traders should endeavor they have a higher stop loss and higher profit target in place, due to heightened volatility.
A tight stop and a tight profit target should be deployed when volatility is seen to be low, in order to ensure your market survivability.
Also note that a breakout of low volatility sessions implies more strength of bulls or bears, and the best time to exit such orders (except you’re trading breakouts).
Take what the market offers when tweaking profit-targets instead of trying to push the market for a higher profit.
Average True Range trading strategies for scalpers
Keep in mind, there is no correlation between costly or complex trading methods and profitability.
Combining the ATR indicator with the 20-period exponential moving average will be a good way to kick-start your scalping strategy.
The ATR will rightly reveal when volatility in the market is high and you can proceed with determining using other trend-following technical tools probable direction price will head.
Sticking to lower timeframes (1-minute, 5-minute & 15-minute) is also a good way to take profits without getting trapped in.
We have an example of a nice scalping strategy dedicated to the ATR indicator, please use it on the 5-minute trading charts.
Average True Range trading strategies for day traders
Trading the ATR on intraday charts will aid traders to maximize profits via the use of the breakout technique.
This strategy simply makes use of the ATR’s ability to spot low volatility sessions, once this is seen on the price chat, wait for a breakout to happen.
A breakout is said to take place when we see a rise in the volatility (foreshadowing a trend change).
Combining the ATR with other technical tools is the key to creating an intraday strategy.
It is unwise to buy or sell simply because the price has jumped and the daily range is bigger than normal.
Only take a valid market position (sell or buy) based on confirmation from other technical indicators like Bollinger Bands, Moving Averages, etc.
I highly recommend that you pay attention to 30-minute & 1-hour timeframes.
We’ve also highlighted here an average true range trading strategy that is designed for day traders.
Average True Range trading strategies for swing traders
Swing traders can deploy the average true range in formulating a strategy that works.
We are fully aware that without volatility we would be unable to execute any trade.
Thanks to the ATR, swing traders can filter out the situations that they’ll love to avoid in the market.
Please check out our example here of how average true range indicators can be incorporated into swing trading strategies.
Conclusion
The possibilities that the Average True Range offers are countless, couple with its numerous profit opportunities that creative investors can make sense of.
It is quite a useful indicator that long-term traders can deploy to monitor their trades since they are sure to anticipate an increase in volatility whenever the number on the ATR has stayed relatively stable for an extended period of time.
The ATR is an amazing tool when we need to deal with and adjust to changing market conditions.
The ATR indicator is also a great tool that can let us see possible turns in the market, upon noticing a significant volatility change.
Some of the inconsistent results that many traders experience is as a result of inflexible trading approach.
A combination of higher timeframes and volatility behavior along with the differences present in uptrends and downtrends, the ATR is indeed a complete trading tool.