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The Average True Range (ATR) is a common technical analysis indicator designed to measure volatility. This indicator was originally developed by the famed commodity trader, developer and analyst, Welles Wilder, and it was introduced in 1978.

The ATR was intended to provide a qualitative approach that would assign a numerical figure to the underlying volatility of an asset. Many traders usually confuse volatility and momentum.

Volatility is the rate at which the price changes relative to the average, whereas momentum refers to trend strength in a particular direction. Based on this, volatile markets have wide price ranges, while less volatile markets have narrow price ranges.

The ATR is designed to purely measure volatility and the indicator neither indicates trend direction nor momentum. By tracking the degree of volatility of an asset, volatility indicators help traders to determine when an underlying asset’s price is about to become more sporadic or less sporadic. Other popular volatility indicators, other than the ATR, include Bollinger Bands and Keltner Channels.

Calculating ATR

The ATR is simply a smoothed average of an asset’s true range values. The range of an asset in any particular time period is simply the difference between the high and closing prices.

However, Welles determined that the ‘true range’ of an asset must take into account previous closing prices so that due consideration is accorded to any price gaps that may have occurred.

Based on this, the true range at any given time period is the greatest of the following:

  1. The difference between the current high and current low
  2. The difference between the current high and previous close
  3. The difference between the current low and previous close

Negative or positive true range values are not taken into consideration, with only the absolute number used in the calculation. After the first ATR is determined, the subsequent ATR values are calculated using the formula below:

Current ATR = [(Prior ATR x (n-1)) + Current TR] / n

Where ‘n’ is the user-defined number of periods

The default ‘n’ on most platforms is 14, but traders can adjust the number according to their needs. Obviously, a higher ‘n’ would result in a slower volatility measure, whereas a lower ‘n’ would result in a faster volatility measure.

Reading the ATR

Interpreting the ATR indicator values is simple and straightforward. When the ATR line edges higher, it implies that the volatility of the underlying asset is increasing; similarly, when the ATR line drifts lower, it implies that the volatility of the underlying asset is decreasing.

Markets oscillate between periods of high volatility and low volatility, and ATR helps traders track these changes.

Having a picture of the volatility can help traders to set definitive price targets in the market. For instance, if the EURUSD currency pair has an ATR of 100 pips over the last 14-time periods, a price target of below 100 pips is more likely to be achieved within the prevailing trading session.

How to Use ATR in Trading

The ATR is used to establish how far an asset’s price can go within a specified time period. This information can be used to trade opportunities such as:

  • Breakouts

Breakouts represent some of the best trading opportunities when trading financial assets. When the price consolidates, the ATR will print low values to denote a low volatility market. Periods of price consolidation are always followed by breakouts, which occur with high volatility. The ATR helps traders to time these breakouts efficiently and gives them the opportunity to join the new trend from its earliest beginnings. After a period of low or flat values, a surge in the ATR will indicate higher volatility in the market and traders can plan how to trade the resulting breakout accordingly.

  • Using a Signal Line

The ATR is only a volatility measure and in a trending market, it will not provide optimal entry points. To remedy this, traders can overlay a moving average on the ATR that will act as a signal line. For instance, traders can add a 20-period simple moving average over the ATR and watch out for crosses. When prices are trending higher, an ATR cross above the signal line will confirm an uptrend and traders could place aggressive buy orders in the market. Similarly, when prices are drifting lower, an ATR cross below the signal line will confirm a downtrend and traders could place aggressive sell orders in the market.

  • Position Sizing

Position sizing is an important element of risk management when trading financial assets. Applying appropriate lot sizes on different financial assets can help traders to minimise risk exposure and enhance their trading effectiveness in the market significantly. As a rule of thumb, high volatility markets should be traded with smaller lot sizes, whereas low volatility markets can be traded with higher lot sizes. Assets, such as gold and Bitcoin, that have higher ATR values, traders can trade them with smaller lot sizes; while assets, such as the EURCHF pair that prints lower ATR values, can be traded with larger lot sizes.

Best ATR Indicator Combinations

The ATR measures only one price element – volatility. This fundamentally means that it is important to combine it with other indicators to identify more qualified trading opportunities in the market. Here are the best ATR indicator combinations:

  • ATR and Parabolic SAR

Parabolic SAR is ideal for trading trending markets. When combined with the ATR, traders are able to set definitive stop loss and take profit price points that will ensure they take full advantage of a trending market with minimal risk exposure as possible.

  • ATR and Stochastics

Stochastics are ideal for trading ranging markets because they deliver overbought and oversold signals. The ATR helps qualify ranging markets and avoid whipsaw signals that can be generated by Stochastics in non-ranging markets. Low ATR values confirm ranging markets and buy/sell signals can be provided by Stochastics crossovers in overbought and oversold zones.

Using ATR for Exit Conditional Orders

No matter the quality of the entry, profit or loss is ultimately determined when a trade is exited or closed. The ATR is efficient in determining optimal price points to place stop loss and take profit orders. For instance, if the GBPUSD pair has an ATR of 150 pips, a take profit of 120 pips is much more likely to be achieved within the particular trading session compared to a take profit of 200 pips.

Similarly, a stop loss of more than 150 pips will give your trade enough breathing room to play out, without the risk of a premature loss. Because it shows rising and falling volatility levels, the ATR can also be used to place optimal trailing stops that will ensure your overall risk is minimised while giving you an opportunity to lock in profits as you ride a trend.

Trade ATR at Friedberg Direct

Trade using the ATR at Friedberg Direct, a regulated Canadian broker, and enjoy the following benefits:

  • Numerous Indicators. The ATR is even more effective when combined with other indicators. There are over 150 indicators available at Friedberg Direct that you can combine with the ATR as you wish.
  • Multiple Assets. Implement ATR strategies on over 100 financial assets that include Forex, Stocks, Commodities, and Indices CFDs.
  • Trading Tools and Resources. Friedberg Direct offers comprehensive trading tools and resources that help traders get the most out of their trading activity.
  • Demo Account. Test various ATR strategies on a free demo account without putting any money on the line.

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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.