Read in today's article:
1. What does ATR indicator mean
2. Why is it important for the trader to know ATR
3. ATR identification and calculation methods
4. How to use ATR when trading
5. Mistakes made when trading ATR
ATR is one of the key technical indicators which every trader needs to have in his/her own trading arsenal. In today’s article, we will explore what it is, how it can be calculated and applied in practical terms in the course of trading.
What does ATR indicator mean
Before you start using any tool, it is absolutely vital to know and understand its essence and intended purpose. Let's begin with what ATR is all about.
ATR stands for the Average True Range and is a technical analysis indicator that measures volatility by decomposing the entire range of an asset price for that period.
His is its primary use. Without knowing its subtle aspects, you may make mistakes when using it which we are going to discuss later on.
Why is it important for the trader to know ATR
Why should the trader know the Average True Range? It is common knowledge that financial instruments occasionally change their direction when moving.
In order to be able to make profitable trades, the trader needs to have an understanding of the price movement direction, how long it is going to last and when the reversal is likely to take place. Oftentimes, it is not easy to clearly determine whether the price will keep going up or will reverse by using regular technical analysis or trend indicators.
If you ever found yourself in a situation where the price would reverse against you by technically accurate entry, ATR will become an additional tool to help you find the right solution when being stuck at a crossroads. If the ATR does not provide the answer to our question about the direction, we will be able to learn about the movement range in a specific direction.
ATR identification calculation methods
Before you proceed to the practical application of this tool, let’s examine its calculation method. You can determine the True Average Range of the price fluctuation either visually (manually) or automatically by using the trading indicator intended for this. Both methods are equally effective. Typically, 14 period i.e. 14 candlesticks are used for this.
To determine the ATR visually (manually), you have to select 14 candlesticks back to back on a timeframe that you are using for trading, excluding the paranormal ones which are too big and normally stand out (typically formed on the news).
After that, from the chosen candlesticks, determine the average-sized one by eye and find out its parameters - the maximum and minimum. To get the ATR value, subtract the minimum value from the maximum value of the candlestick. E.g. 1.2083 - 1.1980 = 0.0103, which is 103 pips.
ATR indicator available on the majority of trading platforms has been specifically designed to automate the above process. If you are using MetaTrader 4 trading terminal, you can find it in the indicator menu in the folder with oscillators. By dragging it onto the chart while holding down the left mouse button, you will see the ATR curve which will appear in a new window. The default period in the settings is 14, and you don’t have to make any adjustments to it.
For trading, we only need to know the current value of ATR. It is displayed in pips and shows up when you hover the cursor over the end of the chart line and near the name of the indicator in the window’s upper left corner. Thus, 0.0096 value shall mean 96 pips.
How does the Indicator measure the Average True Range? The true range is assumed as a basis. In order to determine it, three following indicators are calculated:
- the maximum value of the candlestick minus its minimum value;
- the closing price of the previous candlestick minus the maximum of the current candlestick;
- the closing price of the previous candlestick minus the minimum of the current candle.
The software chooses the largest of the three values and calculates it as a true range. The average value of this indicator for the last 14 candlesticks of the selected timeframe shall be the ATR figure.
How to use ATR when trading
According to the mentioned nature of ATR, knowing its value, the trader can understand whether there is still a movement range of the traded instrument or a reversal is about to happen.
However, it is worth pointing out that it makes no sense to use the ATR as an independent tool. It should be paired with other methods of market analysis and price direction forecasting.
Below are a couple of parameters you can determine by using this indicator:
1. Use the ATR indicator expressed as a percentage to determine how much the price can go in direction of its current movement. Thus, by knowing the value of daily ATR and calculating what percentage of this range the instrument has already passed over a course of a day, you can figure out whether the movement will continue in the said direction or the price will reverse. Accordingly, when 70% of daily ATR has been passed, it is highly likely that the price will change its direction.
2. By intraday trading, it is recommended to factor in the ATR when placing a stop-loss order - its size should be no less than 20% of the ATR. For instance, if the price of the chosen instrument fluctuates within 80 pips over the course of a day, the stop-loss order shall be at least 16 pips.
3. Factor in the ATR value as a reference point when placing the take profit order. In order to do this, take the ATR indicator in pips and subtract the number of pips already passed by the price from it. You will get the movement potential until the end of the period. Place take profit order which size is slightly smaller than the obtained value.
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Let’s examine the application of these rules through an example. If you are experienced in trading, you have quite possibly come across the following situation. The price of the selected instrument gets consolidated in the side corridor under a strong technical level for a while.
In accordance with the rules of the technical analysis, if the price breaks out this level from top downward and consolidates above it, it will keep increasing and so it makes sense to open the short position.
In this case, a trader will face a dilemma: to enter and risk getting a stop loss if the breakout happens to be false, or not to enter and see the price continuing to go up dramatically following consolidation?
This is where the ATR indicator will offer a clue that will help you determine the most likely scenario and make the right decision.
That being said, there is one challenge in this scenario: when the price breaks out the level, the said breakout may turn out to be both real - which will be followed by increase - and false, which results in a price returning under the broken horizontal line following the breakout and several candlesticks above the level.
Now, let’s examine the same situation involving the use of the ATR value. We see that the average true range of the price fluctuations a day is 0.0089 i.e. 89 pips. We check out the chart and determine how many pips the price has passed since the beginning of the day until the breakout.
Should this value be less than 50% of the ATR (in our situation, it is less than 44 pips), there is potential for growth and the trade can be opened. The greater the gap until the ATR, the bigger the potential profit. Depending on the distance passed since the beginning of the day, there are three following solutions.
Solution 1. For instance, given the technical landscape described above, the price of the instrument has passed 15 pips which means that there is a high likelihood that it can increase by additional 74 pips. First of all, the trader understands that he or she can open such a trade, and second of all, he or she is aware of the size of the potential take profit order. It should be slightly smaller than 74 pips determined by us.
Solution 2. The trader sees that the majority of the ATR per day has passed at the time of level breakout, so in this area, there is a high likelihood of false breakout and that the price will reverse. In turn, this means that it is better not to enter the long position since there is no movement range for growth. That being said, it is not recommended to open a short position either. Instead, wait for the next day and figure out your next step based on volatility and technical landscape.
Solution 3. Since the beginning of the day, half of the ATR has been passed on average. If you open a trade, the likelihood of its testing in the black will be 50:50. In this case, the values of the stop loss and take profit orders will be approximately equal. In such a situation, every trader makes decision based on own trading system. If it allows making trades with 1:1 risk/reward ratio, this type of position is acceptable.
In addition, it makes sense to take into consideration the availability of additional signals given by other technical indicators in order to confirm the accuracy of the solution. Otherwise, it would be better to give this entry a miss.
Mistakes made when using ATR
As it has been previously mentioned, the ATR demonstrates volatility fluctuations. It does not show the price movement direction, the overbought and oversold areas and does not provide entry points.
In this sense, make sure you avoid the following mistakes when using the Average True Range indicator:
1. Do not attempt to identify the price direction by means of the ATR. If the indicator line moves upwards, this does not mean that the price of the instrument will go up. This means that the price fluctuation range is expanding, and vice versa. Use other tools to identify the direction.
2. Do not use ATR in order to identify overboughtness and oversoldness of an instrument. It is not intended for this, just like the relevant levels as in Stochastic.
3. It makes no sense to look for a divergence between the ATR chart and the price chart. First of all, based on the nature of the indicator, it is completely wrong, and, second of all, MACD and Stochastic work much better for this.
4. Do not compare the values of ATR with respect to different instruments or on different timeframes of the same instrument. It provides zero information. All you need to know to apply ATR practically is ATR’a current value.
Summing up the above, trading with the use of the ATR allows the trader to elevate the percentage of profitable trades by gaining an understanding of the volatility range.
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