What is ATR?
Average True Range is another indicator developed by J. Welles Wilder, and proposed in his 1978 book - New Concepts in Technical Trading Systems. Average True Range is a volatility indicator. ATR displays the degree of volatility, in other words, shows the average move of an asset during a given time frame. The indicator is used to complement other trading signals for trade entries and is a popular indicator for trade exits.
The formula to calculate the Average True Range is the following:
ATR = ((Previous ATR x Periods - 1) + Current TR) / Periods
Where TR is the True Range, which is calculated as follows:
TR = max(high, previous close) - min(low, previous close)
The final outcome of the Average True Range calculation is usually plotted on a chart below the main price chart. We can see an example of a plotted ATR indicator from Fondex cTrader below.
To add an ATR indicator in Fondex cTrader, right-click on the chart and navigate to Indicators > Volatility > Average True Range. After clicking on Average True Range, the below form will appear.
In this form you select the ATR periods, the MA Type, customize your line’s color thickness and type, and press OK. As soon as you press OK, the ATR indicator will be added to the bottom of your screen.
Using ATR in trading
In contrast to other indicators like moving averages and oscillators, average true range is rarely used as a primary indicator for generating trading signals. ATR is mostly used as a confirmation indicator, or as an indicator for preventing false signals coming from other sources. As explained above, ATR is a figure that provides information about the current market volatility. It also indicates how much the markets moved in a certain direction. For example, ATR can be used to prevent late entries from trend entry signals coming from trend indicators or other sources of technical analysis. A high ATR value at the moment you are receiving a trend signal is an indication that you might have come late to the party, since the high ATR value indicates a high activity during the previous periods, signalling that the trend might be nearing its end. So even if you got an entry signal from e.g. a MACD crossover, it might not be such a good idea after all. Below we can see some cases like this in Fondex cTrader.
In the chart above, we can see a typical three SMA setup. The yellow rectangle highlights a setup and potential signal for a sell position, since both the short and medium EMAs cross the slow EMA from above, a short signal in such a strategy. If we monitor the ATR indicator at the same time, however, we can notice that before the crossover took place we had a non-typical increase of volatility. If we look at the chart, we can observe that the price fell unusually fast, not allowing the EMAs to follow accordingly. The high ATR level hints that this signal might have arrived a little bit too late, and that the trend might have already been exhausted. Indeed, the price movement following this event confirms the concerns raised by the ATR. In this case, the ATR indicator would have saved us from a false positive and a reversal that would lead to potential losses.
The chart below demonstrates the opposite scenario
This time, we can notice a buy signal generated by the EMA crossovers. In this case, ATR tells us that the volatility is rather low compared to the rest of the time, showing that the market was in a phase of consolidation and that a new trend might be in the making. Now the average true range indicator works as a confirmation indicator, providing us with more confidence about the expected price movement direction. Indeed the forthcoming market action confirms this expectation.
Another major use of the ATR indicator is that of an indication as to where to place your stop losses. The ATR value is displayed in pips, and it is a good metric of the range the market is moving within at that moment, so traders usually place their stop losses further away than the ATR (usually at a distance of 1.5 or 2 ATR), so that they allow their trade to absorb noise caused by market volatility and close their positions when the price starts moving in the opposite direction beyond the current volatility range. A popular subproduct of the ATR indicator is the ATR Stops indicator, which plots the stop levels directly on the price chart. Below we can see ATR Stops plotted on a Fondex cTrader chart
The green line above and below the chart prices indicates the appropriate levels for a stop loss to be placed when a position is opened. ATR stops are also frequently used as trailing stop loss levels in automated strategies.
Limitations of the Average True Range
Average True Range, as any other technical indicator, always needs to be used in context. An out of context interpretation of ATR values can generate a lot of false signals that could lead to substantial losses. Therefore, when using the ATR indicator, always consider the fundamentals that currently move the market, and combine the signals with other confirmation signals, such as trend indicators, support/resistance levels and the relevant price action taking place on the chart.
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