Average True Range
he Average True Range is a volatility indicator measuring how much the price of an asset has moved over a certain number of periods, in other words how volatile the asset is. It was created by J. Welles Wilder and was featured in his book “New Concepts in Technical Trading System”. It was originally designed as a volatility indicator able to capture gaps in commodities, since a volatility formula based solely on the high-low range would miss that movement. However, the ATR can be used for stocks, indexes and currencies as well.
What traders use the ATR for is to determine their profit target and the optimal price level for placing protective stops by predicting how far the asset may move in the future. The Average True Range is most commonly calculated on a 14-period basis, but as with most other indicators, it can be fine-tuned according to each traders unique trading system.
The ATR is a directionless indicator, basically a type of moving average of the assets price movement over a certain period of time, which does not indicate the direction of the trend. You can see how the ATR is visualized on a chart on the screenshot below.
As you can see, We have plotted in every opened trade the value of the ATR at that moment. We've used the default 14-period basis, which means that the average price movement over the last 14 periods ( candles ) is 151 pips for the first trade, 137,8 for the second, and 196,2 for the last one. A trader can therefore expect the price to move within the range of 151 / 137 and 196 pips during these trades, thus giving a hint of where his/her profit target and protective stops should be.
As you can see. We have used 2 methods for using the ATR on these trades.
On the first trade, we have opened a position on the pullback of the previous Resistance, the SL and the TP have been calculated using the ATR multiply one time.
151 pips for the SL and 151 for the TP.
The second trade is based on a continuation trend strategy and also on this occasion the TP and SL have used the multiply ATR 1 time.
Last trade, Again Pullback on previous support with ATR multiply 2 times.
How is the ATR calculated?
The Average True Range is calculated by estimating the True Range for each of the included periods and then finding their average using a formula, which is shown below.
The True Range is defined as the greatest of the following:
– The difference between the current high and the current low
– The difference between the current high and the previous close in an absolute value
– The difference between the current low and the previous close in an absolute value
The first scenario is used when the current high is above the previous period's high and the recent low is below the preceding period's low (the previous candle is engulfed by the current one).
The second and third scenarios are used when a gap has occurred or the current period is engulfed by the previous period. Since Wilder was interested in measuring the distance between two points, and not in the direction of movement, here we use absolute values.
After we've calculated the True Range for each period we have decided to track back, we must now calculate the Average True Range by adding these values and calculating their average (as we've already said, the ATR is a moving average of the TR values).
As mentioned before, the most commonly used and set as default in most trading platforms' period settings is 14 periods. After we estimated the ATR for the initial 14 periods, we must then use the following algorithm to estimate future values:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
How to trade the ATR
You've already learned that the Average True Range acts as a tool to measure the degree of interest or disinterest in a price movement. This means that inspiring moves are often accompanied by large TRs, especially at the beginning of a move, while weak moves are followed by narrow ranges. This allows us to use this indicator to gauge the enthusiasm behind every move, including breakouts.
For example, a price reversal, accompanied by an increase in the ATR value would suggest strong sentiment toward that move and reinforce the reversal, while a weak ATR would suggest proceeding with caution.
This is also true when the price breaks through support or resistance. If the breakout is supported by a rise in the ATR, it will be most likely a real move, but waning support from the indicator would suggest that the breakout might be false.
What traders use the ATR for is to determine their profit target and the optimal price level for placing protective stops by predicting how far the asset may move in the future. The Average True Range is most commonly calculated on a 14-period basis, but as with most other indicators, it can be fine-tuned according to each traders unique trading system.
The ATR is a directionless indicator, basically a type of moving average of the assets price movement over a certain period of time, which does not indicate the direction of the trend. You can see how the ATR is visualized on a chart on the screenshot below.
As you can see, We have plotted in every opened trade the value of the ATR at that moment. We've used the default 14-period basis, which means that the average price movement over the last 14 periods ( candles ) is 151 pips for the first trade, 137,8 for the second, and 196,2 for the last one. A trader can therefore expect the price to move within the range of 151 / 137 and 196 pips during these trades, thus giving a hint of where his/her profit target and protective stops should be.
As you can see. We have used 2 methods for using the ATR on these trades.
On the first trade, we have opened a position on the pullback of the previous Resistance, the SL and the TP have been calculated using the ATR multiply one time.
151 pips for the SL and 151 for the TP.
The second trade is based on a continuation trend strategy and also on this occasion the TP and SL have used the multiply ATR 1 time.
Last trade, Again Pullback on previous support with ATR multiply 2 times.
How is the ATR calculated?
The Average True Range is calculated by estimating the True Range for each of the included periods and then finding their average using a formula, which is shown below.
The True Range is defined as the greatest of the following:
– The difference between the current high and the current low
– The difference between the current high and the previous close in an absolute value
– The difference between the current low and the previous close in an absolute value
The first scenario is used when the current high is above the previous period's high and the recent low is below the preceding period's low (the previous candle is engulfed by the current one).
The second and third scenarios are used when a gap has occurred or the current period is engulfed by the previous period. Since Wilder was interested in measuring the distance between two points, and not in the direction of movement, here we use absolute values.
After we've calculated the True Range for each period we have decided to track back, we must now calculate the Average True Range by adding these values and calculating their average (as we've already said, the ATR is a moving average of the TR values).
As mentioned before, the most commonly used and set as default in most trading platforms' period settings is 14 periods. After we estimated the ATR for the initial 14 periods, we must then use the following algorithm to estimate future values:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
How to trade the ATR
You've already learned that the Average True Range acts as a tool to measure the degree of interest or disinterest in a price movement. This means that inspiring moves are often accompanied by large TRs, especially at the beginning of a move, while weak moves are followed by narrow ranges. This allows us to use this indicator to gauge the enthusiasm behind every move, including breakouts.
For example, a price reversal, accompanied by an increase in the ATR value would suggest strong sentiment toward that move and reinforce the reversal, while a weak ATR would suggest proceeding with caution.
This is also true when the price breaks through support or resistance. If the breakout is supported by a rise in the ATR, it will be most likely a real move, but waning support from the indicator would suggest that the breakout might be false.
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