Using the Average True Range (ATR) indicator: A comprehensive guide

When setting stop loss and take profit, the question is always, “How high or low will the price go?” Since fundamental analysis only helps traders understand the direction, traders turn to technical analysis to define limits. When not in a crash or rally, an asset will usually bounce up and down within an established range, but there’s one indicator designed especially for identifying price ranges: the average true range or “ATR indicator.”

Content

1. What is the Average True Range indicator?
2. The significance of ATR in technical analysis
3. The ATR in trading
4. Common questions about the Average True Range indicator
5. Key takeaways
6. Final thoughts

What is the Average True Range indicator?

The ATR is a technical indicator used in financial market analysis. It calculates a price's volatility over a certain period, indicating whether the movement is strong or weak. For instance, a high ATR denotes high volatility, while a low ATR suggests low volatility.

Introduced by J. Welles Wilder Jr. in his 1978 book “New Concepts in Technical Trading Systems,” the ATR was initially developed for commodity markets but has since been applied across various financial instruments.

While ATR can be extremely useful in trading, its limitations must be acknowledged. Firstly, it's a subjective measure and open to interpretation, meaning there's no specific ATR value that confirms whether a trend will reverse or not. Secondly, ATR measures volatility, not the price direction, potentially leading to misleading signals, especially when trends are at inflection points.

The significance of ATR in technical analysis

Average True Range (ATR) is crucial in technical analysis and risk management for several reasons. Primarily, it helps measure an asset's price volatility, a key factor for investors to identify risks and profit expectations. With this information, investors can tailor their strategies, improving, changing, or canceling them.

Besides measuring volatility,the Average True Range is also used to identify market changes. An increasing ATR can signal significant price movements. Furthermore, it confirms the strength of uptrends or downtrends. For instance, if the price and ATR rise, the uptrend gains momentum. Conversely, a falling ATR during a downtrend suggests losing momentum.

Traders leverage ATR to compare financial assets, determining which are more stable or volatile—crucial data for capital allocation in investments.

Components of the Average True Range (ATR)

Understanding ATR's components is vital for its calculation. The True Range (TR), the basis of the ATR indicator, is computed as the greatest of the following:

• The current period's high minus the current period's low.
• The absolute value of the current high minus the previous close.
• The absolute value of the current low minus the previous close.
• The Average True Range is the mean of True Range values over a specified period.

ATR calculation and value interpretation

On a chart, the ATR is represented by a line and a 14-day smoothed moving average. The TR is calculated using the highest of the three following values:

• The difference between the current high and low.
• The absolute difference between the current high and the previous close.
• The absolute difference between the current low and the previous close.
• ATR, crucial for gauging volatility, doesn't measure price direction but volatility. Only after calculating the True Range can one identify the Average True Range, essentially viewed as a moving average of the TR.

The ATR is derived by computing a moving average (usually exponential) of the True Range over a specified number of periods, typically 14-day periods by default. However, traders may adjust this number based on their preferences.

An upward-moving Average True Range line indicates increasing volatility, potentially signaling entry points for some traders. High volatility isn't just indicative of potential higher returns but also escalates the risk of losses.

Traders often close trades when the Average True Range reaches high values and begins to indicate a potential reversal. Conversely, a smoothing and decreasing Average True Range line signifies periods of low volatility.

The ATR in trading

The ATR indicator is pivotal in trading for risk reduction, capital protection, and profit maximization. Its versatility and ease of integration into investment strategies make it a go-to tool. ATR assists traders in making informed decisions and, when used alongside other indicators, can significantly enhance investment strategies.

How to use the Average True Range indicator

1. Position sizing based on market volatility: Adjusting trade sizes to volatility is crucial for the success or failure of a trade. Higher volatility equates to higher risk, and lower volatility means lower risk. ATR can be used to develop strategies that balance this risk by limiting the size of the operation.
2. Setting stop loss Levels: Another key use of ATR is setting stop loss levels. What is a stop loss? A stop loss refers to an order that sets a maximum loss level when investing. Traders use the volatility indicated by the ATR to set wider or tighter stop losses. Implementing stop loss limits potential losses, facilitating more effective gain/loss management.

The image above shows how ATR has been applied to a gold chart. The $32 value means the stop loss is less than $32 away from the entry price and will likely be triggered within the next day or two.

3. Identifying Breakouts and Reversals: ATR can help identify breakouts and reversals in several ways. It allows traders to pinpoint volatility levels of an asset's price over a specific period. A peak in the ATR could signal breakouts or significant changes in values. Additionally, an increasing ATR may indicate that a breakout movement is gaining momentum.

4. Overbought and Oversold Conditions: ATR is used to identify overbought and oversold conditions. Extreme volatility conditions can signal opportunities for potential reversals. If the ATR has been steadily rising and reaches extremely high levels, it might indicate the market is overextended, and a reversal could be imminent.

Common questions about the Average True Range indicator

Is the ATR a good indicator?

Traders widely use the Average True Range (ATR) to measure market volatility. Since ATR is based on historical price data, it helps identify how much an asset typically moves over a specified number of periods. While ATR does not indicate price direction, it is useful for gauging potential price fluctuations. Combining ATR with other indicators like the Relative Strength Index (RSI) can improve trade decisions by considering both volatility and momentum.

How do you use the ATR indicator to set a take profit?

Traders often use an asset’s trading range, measured by ATR, to determine realistic price targets. A common approach is to set take profit levels at multiples of the first ATR value. For example, if the ATR is 1.5 and a trader aims for a 2x ATR move, the take profit level would be set at three points from the entry price. This method ensures that the take profit targets align with recent price volatility.

What is the best average true range setting?

The optimal ATR setting depends on the trading strategy. The standard calculation for ATR uses multiple 14-day periods, which works well for many traders. However, shorter periods (e.g., 7) provide more responsive signals, while longer periods (e.g., 20+) smooth out fluctuations. Calculating ATR over different timeframes can help adapt to varying market conditions.

Is ATR good for day trading?

Yes, ATR is effective for day trading as it helps assess intraday volatility. By calculating the ATR on shorter timeframes (e.g., 5 or 15-minute charts), traders can adjust their price targets and stop-loss levels dynamically. A high ATR suggests larger potential trading ranges, making it useful when setting risk-reward ratios.

Key takeaways

1. ATR measures volatility, not price direction: The average true range indicator (ATR) is a key technical tool used to gauge market volatility by analyzing historical price data. However, it does not predict whether the price will increase or decrease, making it best suited for identifying the strength of trends rather than their direction.
2. ATR helps when setting stop loss and take profit levels: Traders use the ATR indicator to set trading range-based stop loss and take profit levels. A multiple of the first value of ATR can determine realistic profit targets. For example, if ATR is 1.5, a trader may set a price target at three points for a 2x ATR move.
3. ATR settings can be adjusted based on strategy: The default ATR calculation uses several 14-day periods, but traders can modify this to suit their trading style. Shorter periods (e.g., 7) provide more responsive signals, while longer periods (e.g., 20+) smooth out price fluctuations. Calculating ATR across different timeframes allows for better adaptability in trading strategies.
4. ATR identifies breakouts, reversals, and market conditions: A rising ATR suggests increasing volatility, which can indicate a breakout or the continuation of a trend. Conversely, a declining ATR signals decreasing volatility, often associated with consolidation or potential reversals. High ATR values can also indicate overbought or oversold conditions.
5. ATR is essential for risk management in trading: The ATR indicator is widely used for risk control by helping traders adjust position sizes according to market volatility. A high ATR suggests a wider trading range, requiring a more cautious approach, while a low ATR allows for tighter stop losses. Calculating ATR before entering a trade helps manage potential risks effectively.

Final thoughts

Using this knowledge, you can incorporate the ATR indicator into your trading operations. Remember, like any trading method, ATR isn't foolproof. It's best used as one of many tools in a comprehensive strategy that takes multiple factors into consideration.

In conclusion, the ATR indicator is a critical tool in a trader’s arsenal, helping to mitigate risks, safeguard capital, and maximize profits. Its versatility allows it to be integrated seamlessly into various trading strategies, providing valuable insights into market volatility. However, it's crucial to remember that ATR, while informative, does not guarantee success on its own and should be used in conjunction with other analytical tools and sound trading practices.