Average True Range (ATR)
Average True Range is a technical indicator in the commodity market which was later evolved into the Forex and equity market as well. It has been created by a technical analyst ‘J. Welles Wilder’ in his well-renowned book, “New Concepts in Technical Trading Systems.”
This famous indicator measures the currency’s volatility by taking price movement into account. In other words, ATR measures the average of the true ranges in the given number of periods. The number of periods is typically set to 14.
The indicator can be used over different timeframes. The period’s value is set between 2 to 10 to measure the short-term volatility and 20 to 50 for long-term volatility. ATR also helps the traders in determining their take profit and stop-loss points.
Calculation of Average True Range
Mathematically, a trading range is the difference between the high price and low price. The true range considers the previous closing price as well.
True Range is the maximum / largest of the:
- The present high minus present low
- The absolute value of present high minus previous close
- The absolute value of present low minus previous close
True Range (TR) = max [(high – close), abs(high – previous close), abs(low – previous close)]
Now, the formula to calculate the Average True Range at the bar x is
ATRX= (ATRX-1* (n-1) + TRX) / n
And the first value of ATR is calculated as,
ATR = 1/n ∑ TRX
ATRX– the moment of time for which ATR is being calculated. Example, if x =today,
ATRtoday = (ATRyesterday * (n-1) + TRtoday) / n
TRX– specified true range
n– time period (number of days- typically 14)
∑ TRX– summation of TR from x=1 to n
As previously mentioned, ATR is an indicator whose primary purpose is to represent the volatility in the market. With the help of the volatility, we can examine how much a currency has moved up or down on an average, over a specified period.
If the value of ATR is high, that implies the volatility is quite high in the market, and a low value of ATR implies that the prices are not moving in large amounts and are pretty feeble.
Market Analysts use this indicator to determine the right time to enter and exit a trade. A short-term trader uses a five-day ATR to know the volatility in the recent five days while a long-term trader uses about twenty-day ATR to find the volatility in the past 25 days.
Reading the ATR
Consider an example of AUDUSD in the Daily timeframe. ATR is plotted for the same. The period of ATR is set to 14. For instance, if the value of the ATR is 0.00445, it means that the pair moves by 0.00445 on an average per day. In other words, AUDUSD moves around 44 pips per day. Therefore, traders can expect the price to move about 44 pips in one day.
Reading volatility: Here, the purple boxes represent high volatility, while the blue boxes represent low volatility.
Step by step installation process on the MetaTrader 4
Below is the main screen of the MT4 trading platform.
Step1: From the main screen, hit “Ctrl + N” which displays the navigator box. Next, click on the indicator option, which will show up a set of types of indicators.
Step2: From the set of indicators, choose the oscillator option as shown below.
Step3: From the indicators available in “oscillator,” select the Average True Range indicator. This will result in a window where the parameters of ATR can be changed. The default value of the period is set to 14, and it can be altered upon the user’s choice.
Pros of the Average True Range
- Price action traders find ATR to be a handy indicator. Once they are in a trade, to determine how long will the trade take to perform, they rely on the value of ATR.
- ATR Trailing stop loss strategy: Trailing stop loss is a way to exit a trade. It is used to decrease the losses or increase profit. As the price moves in favour of the trader, the stop loss also moves in the same direction. Now, ATR is used with trailing stop loss to refine the stop loss. Let’s consider a buy example. Here the stop is placed as a multiple of ATR value. Usually, the stop loss is set at two *ATR below the buy price. As the trade performs in the desired direction, the stop loss is moved to 2 * ATR above the current price. This is done until the target is reached or stop-loss is hit. Similar is the case for a sell as well.
Example: If a long trade is taken at the price of $50, and the ATR value is 0.8. So, the stop loss is placed at $48.6 (50 – 2*0.8). Now, if the price rises to $53 and the ATR value remains 0.8, then the stop loss is moved to $51.4 (53 – 2*0.8). This helps in locking in a reasonable amount of profit and also reducing risk along the way. Therefore, this is a useful risk management technique.
Cons of the Average True Range
The ATR indicator alone does not predict the future trend in the market. It is only a measuring tool that measures the volatility in the market. Other than this, this indicator does not have any significant disadvantage.
The range of an asset is a measure of its movement on a particular bar. If the bar is short the range is small. If the bar is large the range is also large. The Average True Range essentially shows the average of that range in a specified amount of bars, usually 14. Primarily, it helps in determining the volatility changes in the market.
The time period of ATR is usually fixed to 14, and it can also be changed on the user’s choice.
Periods less than 14 bars results in a choppier read of the indicator and any value above 14 results in a smoother read.
The larger the ATR value, the greater is the volatility and lower the ATR value, the weaker is the volatility. ATR is an excellent risk management tool used by technical indicators as it helps in placing stop losses.