I am writing this article because I see that some traders like to use ATR indicator, and many other traders wonder what advantages this indicator has and how it can help. Those who know and have been following us know that candlesticks and Bollinger Bands are the only trading tools we use, and we don’t need any other indicator in our trading system. However, as we are are usually asked about some indicators, I prefer to write articles about them to answer the questions.
Among the many tools that we use for the analysis of the trades, there are some that are very popular while there are some that might be sparingly used. Technical traders too have their individual specific likes and dislikes and like to operate in their own comfort zone.
Volatility as a tool to interpret price action and price pattern in trade can be beneficial for many market watchers. One such volatility indicator is the Average True Range or more popularly termed as the ATR. It has a dual purpose and can be used to identify entry and exit points, as well as a complete system of trading, can be developed based on the principles driving ATR. For many decades, seasoned professionals have been using this technique to improve their trade results.
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Definition Of ATR
For a better understanding of The Average True Range, it is important to get a proper understanding of volatility. Essentially volatility measures the overall strength of absolute price action and direction of market trade. But when we discuss volatility indicators perhaps what would come to your mind are Bollinger Bands.
But the limitation of the Bollinger Bands is it only concentrates on volatility without taking into consideration the associated price action.
In comparison, this volatility indicator, ‘The Average True Range’, gives you a lot more comprehensive perspective. In practice, this is nothing but a moving range with an average 14-day chart movement tracked to give an idea about the price action.
Originally this was a tool devised to track commodity market movement but eventually its use spread to the markets and a whole range of index movement. The basic fact that ATR highlights is when a currency pair signals high volatility levels it generally tends to have a higher AR reading and the vice versa, low volatility begets low ATR reading.
The biggest benefit of this indicator is perhaps it gives the traders the option to limit the extent of losses by preparing a firm plan to execute the trade and also enabling identifying stop losses and entry points.
History & Conception Of Average True Range
The ATR indicator was originally conceptualized by Welles Wilder as a tool to measure the volatility in price action. Needless to mention the first port of call for a tool like this was the commodity market with a distinctly higher volatility rate. But given the very volatile trade in the markets now, it is commonly used by the traders too. It is more commonly used to gauge the historical volatility trend rather than get a perception about future price direction.
Also, popularly known as the oscillator, the ATR curve is often seen fluctuating between multiple value points. More of a trailing indicator, standalone direction of price action is not what you can discern using this tool. Very simplistically put what it enables to interpret is when the ATR reading is high you need to put in wider stops and the entry level also needs to be tweaked accordingly.
How To Calculate Average True Range
Well, the most obvious question at this juncture would be so how do you actually arrive at the Average True Range and how can you calculate it. Well, if you have a Metatrader trading platform, you have it automatically there for you courtesy the advanced software. If you need to calculate it on your own, it is not a big issue either. Here are some simple, straightforward steps to arrive at a solution:
First and foremost for any chosen period, you must calculate three key value points
- Firstly the high minus the low
- Then subtract the high from the previous close
- Finally, subtract the previous day’s close from the day’s low
So finally the True Range is the greatest of these three values. Thus as we had discussed earlier, the ATR is more like the moving average over a specific period of time that you might have chosen.
Ways To Use The Average True Range
As all of you would have understood by now that traders can use ATR to gauge market volatility. However as traders you must always keep a close watch on your targets as well as the stop loss number. If you see a spike in the ATR reading, it is prudent to bring into place relatively larger stop losses and suitably alter the profit targets.
Once you get a hang of it, you will be surprised to see how easy it is reading the ATR and using the market volatility to tweak your trading position. The volatility levels can even help you in determining your stop loss and limit order levels on existing position.
It is considered a measure of volatility as this range is nothing but calculation of distance between the high and low points over a specific period. Normally you would have it displayed with decimal points to highlight the exact pip movement between high and lows. The ATR value remains directly proportional to the volatility levels. A decline in volatility will lead to a decline in the pip measure between the highs and lows.
Thus, quite contrary to what happens normally, traders can now actually use the Average True Range and indirectly the volatility levels to manage their positions and optimize their gains. The same volatility that wreaked havoc can actually be tamed and used via ATR for more profitable transactions.
Here is an example that can illustrate this point further. Let us assume that you observe that the volatility has dropped significantly from its historical levels. Normally a low volatility phase is associated with the big moves in the foreseeable future. Now instead of just guessing the trend, you need to only wait for the ATR to increase and you can easily place a trade in the direction of the movement.
1. Using ATR To Determine Profit Targets
Another interesting way to use the Average True Range is for determining your target levels. Especially for day traders, this average range acquires great significance.
For example, if let’s assume the Euro-USD has seen only 70 pips average move over the past 14 days, then you need to rein in your profit target accordingly. Just keeping fantastic targets like 150 pip movement will take you nowhere You will simply end up waiting for profits that do not come and will likely end up losing money. Instead, what you need to do is take the Average True Range for 14 days and divide it into half. The resultant product can act as your profit target. It is safer, better, realistic and with far less. So in this case with the 14-day average pip movement of 70, your profit target is 35.
This kind of estimation would not just be more realistic but will also give you a greater leeway to spread out your trade.
2. The Average True Range Can Work As Filter
If you intend to filter out trades, this can be an interesting medium to do the same. For example, if your trading platform gives you multiple signals, you can easily use ATR to weed out the low volatility ones and concentrate of high volatility trades that yield a lot higher profit.
Thus, essentially what we understand is the ATR is a great way to determine the exit point for a specific trade. In this context, the most popular reference is that of Chuck LeBeau and the technique that has been devised by him and is popularly known as ‘chandelier exit’. In this, the distance between when the specific currency hit its highest high for the given time period and the stop loss level is correlated to the ATR. For example say it is 3 times the value or 4 times the value. The name Chandelier is connected to this theory where it hangs down from the highest point of the ceiling.
Advantage Of Using The ATR
There are many advantages of using the Average True Range. Not only does it help you assess market movement and trends objectively, but also it brings out a lot more precision in the daily analysis of the trade.
These have a distinct advantage over other methods of using a fixed percentage system as the change is based on the varying degrees of volatility. With the gradual expansion and contraction of the trading range for a specific currency pair, the distance between the stop loss level and the closing price adjusts automatically to more appropriate points. This serves the dual purpose of facilitating the trader protect the desired profit as well as allow the specific entity to function within the given market dynamics and far more normal range.
1. ATR Breakout Systems:
This particular approach is extremely adaptive and can be used over any time frame. Particularly for day trading strategies it can be very useful. A trader can even use as small a time frame as 15 minutes to determine the entry point of the day. You have the option to use any time frame, 5-minute, 10-minute ATRs can be generated. You can also place stop losses to close the trade with even loss if the price returns to a certain specific bar.
2. Filtered Wave Methodology:
The Average True Range can be used in this context and adapted to generate data that helps in identifying the turning points in the market. An upwave would be noticed when the price action is seen moving from lowest close up to three ATRs. Price movement three ATRs below the highest close would signal the reverse, that is a new down wave in the specific currency pair which you might be trading and charting.
3. Long-term Outlook:
This technical tool enables investors using it to get an idea of the long-term outlook as phases of increased volatility are generally associated with stable ATR readings over an extended period. This enables traders to be prepared well in advance for potentially turbulent times and avoid making obvious mistakes that panic stricken traders are most prone to committing while trying very hard to safeguard one’s profit interests in the eye of a storm.
Disadvantage Of Using The Average True Range
One thing always leads to the other. Discussion about the advantages of using the Average True Range is bound to also highlight the potential negatives and the facts that you must be careful about while using this technical tool to enhance your trade and maximise the profit potential. These drawbacks might not set you back immediately, but it is worthwhile to understand and take cognizance of these as they help you avoid potential pitfalls and trade with lot more confidence.
Perhaps the biggest problem with this approach is the lack of a system that helps you gauge the exact risk potential. Also, there is always that possibility that the market might break out either above or below the price level you might be pegging the trade at. Perhaps it is wiser that this might not be such a great tool to predict the market pattern ahead of major announcements. Also, trading experts believe that it is not a great tool for highly volatile currency pair like British Pound and Japanese Yen.
Perhaps this point can be better illustrated in tracking the trade that was undertaken in December 2005. On December 14 that year, GBP/JPY kicked off trade at 212.36 but eventually slipped to 206.91 and finally closed at 208.10. Supposing your stop loss was at 210, given the initial trade, you could have suffered huge losses.
Ultimately the efficacy of a tool is strongly dependent on its user and his or her adaptability with changing market conditions. Often times the kind of trader that you might be and a deep insight about your personal strength and weakness can decide the success or failure of a strategy, be it the Average True Range or any other device to tracks and get a handle on the market’s nerve.
The ATR is a highly versatile tool, and the spectrum of possibilities is huge if you have the necessary patience, risk appetite and eye for profit. You ability to spot profit opportunities and how creative you can be in achieving those also are key catalysts for a successful market transactions.
Also, the importance of stop losses never wanes away. A strong stop loss, a well thought out exit plan forms the basis of most successful trades whatever the technical tool you might be using to identify the potential pattern and identify the possible range that a successful trade can be executed. Thus with some care and eye on certain key factors, the ATR can act as a brilliant tool for you to optimize your profit margins in the markets.