Average True Range (ATR) is an indicator designed to the volatility of a market. It was developed by Welles Wilder, who is also credited for formulating the Parabolic SAR and the RSI. ATR does not account for price direction but it factors in price gaps. ATR enables traders in identifying a market’s daily movement and volatility. ATR is calculated using the following three methods that rely on how the candles are formed:
- The current high minus the current low price
- The current high minus the previous closing candlestick price (absolute value)
- The current low minus the previous closing candlestick price (absolute value)
Note- An absolute value means the number is positive
If the range between the current and previous candle is large, then the ATR value will also be large and vice versa.
To obtain the current ATR, the True Range (TR) value is recorded daily and then used in constructing the formula below.
Current ATR = ((Previous ATR * 13) + Present TR) /14
How to use ATR
The ATR indicator can be used with all chart timeframes, whether it is a one- minute chart or 7-day charts. If you use intra-day charts like the Five-minute chart, you will notice huge fluctuations in the ATR adjacent to the open especially if a price gap occurred over the night. During the course of the day, the Average True Range (ATR) will settle and reflect only the movement of that day’s trade.
Despite ATR not being a common trade signal, it is useful for confirming entry points. Once a price declines and then breaks over its trend line, it signals a potential buy. If the ATR breaks over its own resistance, it is an indication of a higher price break.
ATR is also used as an alternative to the traditional profit taking methods and stops. This helps to control risk, profit from the trend and get out before the trend reverses. It’s not exhilarating to put a trade then watch the market hit your stop loss before continuing its movement in your expected direction. This happens when your stop loss is too tight. Ensure your stop loss is broad enough to accommodate the daily market swings. Multiples of ATR are normally used by traders to set an initial stop, and then trail it behind the price. These multiples include 2, 2.5 OR 3. After setting an initial stop,
Traders use a multiple of ATR, often 2, 2.5 OR 3 to set an initial stop, then trail that multiple behind the price. If you want to trade in massive trends, use ATR to trail your stop loss by following the steps below:
- Select your preferred ATR multiple; 2, 3, 5 or any other value
- If you are short, add the (Value) ATR from the lows to get your trailing stop loss
- If you are long, less the (Value) ATR from the highs to get your trailing stop loss
When you use a small ATR multiple, you will trade on a small trend and the time held on the trade will be shorter. A bigger ATR multiple will allow you to trade on a bigger trend and the time held will be longer.
Watching for resistance breaks on the ATR alerts you on the possibility of a strong move occurring.
The following three steps can be used to identify a big breakout trade before it occurs:
- Wait for the volatility to reach multi-year lows when using the weekly timeframe
- Identify the range of that particular duration
- Make trade at the break of the range
When the ATR approaches very high levels in relation to the history of previous years, the price can be extended upwards or downwards. If the ATR breaks below support and there are chances of a reversal it indicates that a price climax is likely to have occurred. The following procedure will also let you know when the market has reached its limits:
- Note the current ATR value
- Multiply the value by 2
- If the market moves twice the ATR value, there is a chance it is exhausted.’
It is evident that ATR is a powerful volatility measure and trade range indicator. ATR readings help a trader to determine the most likely time for a market to range and to identify high interests in a trend. ATR also alerts the trader when extreme levels are being reached; consequently, this indicates that a reversal is on the way. A trader is then able to determine the best time to trade.