I like using the Average True Range indicator in my trades.
Most trading indicators measure trend direction, momentum, overbought levels, etc.
However, the ATR indicator is different.
Actually, it’s totally different from other trading indicators.
And if you use it correctly, it becomes one of the most powerful trading tools.
In this article, I will unearth everything that you need to know about this indicator.
You will realize how awesome this indicator is.
What is the Average True Range Indicator?
The Average True Range is a single line indicator that measures volatility.
Originally, this indicator was developed by J. Welles Wilder for measuring the volatility of commodities within the futures market.
Common indicators like Momentum and MACD measure the price direction or price trends.
The ATR indicator doesn’t.
Instead, it shows when volatility is low and when it is high.
Consider the chart given below…
The above chart shows that the ATR is inserted in a separate window at the bottom of your chart.
The indicator is a single line that fluctuates within a range.
High prints for the line are an indication that the market is experiencing a high volatility.
Also, depressed ATR levels are an indication that the market is experiencing a relatively low volatility.
Traders can rely on the prints of this indicator to determine the entry and exit points based on volatility.
When the volatility is high, the currency pair is most likely to be dynamic and moving faster.
On the other hand, a low volatility is associated with a consolidation period or a quiet market.
The Average True Range is not a common indicator among retail traders like other momentum based indicator.
However, it is a great indicator for traders who are conscious to volatility and who need to gauge the current level of volatility or trying to anticipate potential price breakouts.
Experienced traders know that markets move from periods of low volatility to periods of high volatility and then back again constantly.
How to Calculate the ATR
So, the question is…
How is the ATR value calculated?
Let me give you the answer…
The calculation is done using 1 of 3 methods, depending on how the candles are formed.
These methods include the following…
Method 1: Current high less current low
Method 2: Current high less the previous close
Method 3: Current low less the previous close
To calculate the value of this indicator, you should first identify the true range of the period on the chart.
Consider the graphic given below…
Above we have a graphic divided into three parts, A, B, and C.
In A, the range of the current candle is larger than the previous candle.
So, we use method 1, which is, current high less current low.
In B, the current candle closes higher than the previous candle.
So, we use method 2, which is, current high less the previous close.
In C, the current candle closes lower than the previous candle.
So, we use method 3, which is, current low less previous close.
What you must note is that, the larger the range of the candles, the larger the value of ATR.
The vice versa is also true.
So, a smaller range for the candles means a small value of the indicator.
You can also choose to do calculations using the three formulas.
The highest result that you get should be the actual True Range value for the chart.
After getting the True Range, you can average the values for the period on the chart.
To do the average calculation, you should use an Exponential Moving Average on the values.
The good news is that most trading platforms provide users with this indicator and the values are calculated automatically.
So, you don’t have to do the calculations yourself.
However, for you to use this indicator effectively, it’s necessary to know how the calculations are done.
The default formula uses a 14-period EMA indicator.
However, it’s possible for you to adjust the period that you want to be taken into consideration.
The indicator will the recalculate based on the specified time period.
ATR is not a Trending Indicator
Most traders make the mistake of assuming that trend and volatility go in the same direction.
This is wrong!
Remember what we said…
That ATR measures the volatility of the market.
This means that a market may be trending higher but volatility may be low.
The vice versa is also true.
A market may be trending lower but volatility may be high.
Consider the following chart…
The above chart shows two instances in which trend and volatility seem to contradict each other.
In the first instance shown using red arrows, the market is trending lower but volatility is trending higher.
In the second instance shown using black arrows, the market is trending higher but volatility is trending lower.
So, the ATR is not a trending indicator.
Don’t use it as a way of determining the direction of the market.
How to Hunt for Explosive Breakouts using the ATR Indicator
The volatility of each market keeps on changing.
The market keeps on moving from a period of low volatility to a period of high volatility, and vice versa.
So, when the market is in a low volatility period, you should expect the volatility to pick up soon.
With such knowledge, you can find explosive breakouts before they can occur.
Here is it…
- Wait for the volatility to reach multi-year lows on a weekly timeframe.
- Identify the range during this time period.
- Trade the break of the range.
Consider the chart given below…
In the above chart, we are using a weekly timeframe.
We have waited for the volatility to reach multi-year lows.
This has been shown by the black arrow within the indicator section marked as Multi-Year Low Volatility.
We have then identified the range that occurred during this period.
This is the price action just above this period of the indicator.
The range then broke through the support line.
The Support line is the black line running horizontally on the chart.
The position of the breakout has been shown using a black arrow marked as Break down of Support.
This is the best time for you as a trader to trade the break of the support.
The breakout through the Support is followed by a period of significant price decline.
If you have noticed, this explosive move happened after a period of low volatility.
So, explosive price moves normally follow periods of low volatility.
How to Avoid Getting Stopped out of Trades Prematurely
Have you ever found yourself in this situation…
You enter a trade and watch the market hit your stop loss.
The stop loss exits you from the trade.
Then the market continues moving in your expected direction.
So, you miss out on a profitable trade.
But the reason is that you used a tight stop loss.
So, how can you solve this problem?
Give your trade a room to breathe.
Ensure your stop loss is wide enough to accommodate the daily swings of the market.
Of course, most markets experience daily swings.
But, how wide should the stop loss be?
The Average True Range indicator can help you know this.
Here is how…
- Determine the current value of ATR.
- Choose a multiple of the value.
- Add the amount to the nearest support and Resistance level.
This means that if you are long from Support and you have a multiple of 1, you should set your stop loss 1 ATR below the lows of the Support.
And if you are short from Resistance, with a multiple of 2, set your stop loss 2ATR above the highs of Resistance.
Consider the following chart…
In the above chart, we began by determining the current value of the ATR indicator, which is 76.0.
We have then used a multiple of 1 to know where to set the stop loss.
The stop loss should be set 76 points from the support.
This is enough space to ensure that there is enough room for swings.
Your stop loss will not be triggered by minor swings in the market.
Hence, you will not be stopped out from a trade when it’s too early.
This will increase your chances as a trader of making more profit.
How to Ride Big Trends using the ATR Indicator
If you need to ride big trends in the market, you should use a trailing stop loss on your trades.
With a trailing stop loss, you can exit a trade if the currency pair moves against you and also shift your exit point if the price moves in your favor.
Most day traders use the ATR indicator to know where to place their trailing stop loss.
You can use this indicator to trail your stop loss.
Let me show you…
First, you have to determine the ATR reading.
You should then choose a multiple that you will be using. This can be 3, 4, 5, or any other value.
If you are in a long position, just minus X ATR from the highs. The result should become your trailing stop loss.
If you are in a short position, add X ATR from the lows and that will become your trailing stop loss.
If you have chosen a multiple of 2 and you want to enter a long position, just place your stop loss at 2ATR below the entry point.
If you want to go short, place your stop loss at 2ATR above the entry point.
That’s how easy it is to determine where to place the stop loss when using this indicator.
Now that you know how to place the trailing stop loss, how do you shift it?
Let me show you…
Of course, where to shift your trailing stop loss will be determined by your trading position and the direction taken by the price.
If you are in a long position and the price moves in a direction that favors you, keep on moving the stop loss to 2ATR below the price.
In this scenario, the stop loss should only move upwards, not downwards.
Once the trailing stop loss has been moved up, it should stay there until it can be moved up again or until the price reverses and triggers the stop loss, in which case the trade should be closed.
If you are in a short position and the market moves in a direction that favors you, keep on moving the trailing stop loss 2ATR above the price.
In this case, the trailing stop loss should only move downwards, not upwards.
Once the trailing stop loss has been moved downwards, it should stay there until it can be moved downwards again or until the price reverses and triggers the stop loss, in which case the trade should be closed.
An indicator named “Chandelier stops” makes this work easier for you.
Consider the chart given below…
The above chart shows how we can use 3ATR as the trailing stop loss.
This means that we are using a multiple of 3 to determine the position of the trailing stop loss.
The dotted line running across the chart is the “Chandelier stop” indicator.
Most trading platforms provide this indicator.
The first arrow points to a position at which the trailing stop loss is 3 ATR from the lows.
The second arrow points to a position at which the trailing stop loss is 3 ATR from the highs.
So a common question raised by many traders is…
“Which is the best ATR multiple to use?”
The truth is that there is no best ATR multiple.
If you choose to use a small ATR multiple, you will ride a small trend, and the time held on a trade will be shorter.
If you choose to use a bigger ATR multiple, you will ride a bigger trend, and the time held on a trade will be longer.
So, it’s up to you to choose the approach that best suits you.
So, let me give you a simple rule that you can use to determine the position at which you should place your stop loss.
If the indicator line is located in the upper half of the area, it acts as a signal that the market is relatively volatile.
This means that you should set a loose stop loss in the market.
If the indicator line is located in the lower half of the area, it acts as an indication that the market is less volatile than normal.
This means that you should consider using a tighter stop loss order.
If you consider the above rule of thumb when placing your trailing stop loss, you will always stay on the safer side of the market.
How to use the ATR Indicator to set the Profit Target
You may not have interest in riding trends.
If that is the case with you, you can use the ATR indicator to set the profit target.
It works as follows…
You are aware that the ATR indicator tells you of how much a market can potentially move for the day.
If a currency pair has a daily ATR of 100 pips, it means that it moves an average of 100 pips in a day.
This means that day traders can have a target profit of about 100 pips (give and take).
There are high chances that this profit target will be hit.
However, you don’t have to blindly set a profit target of 100 pips.
This way, you will be able to know where the price may reach for the day.
Let me give you an example…
Suppose the CAD/CHF pair moves at an average of 100 pips in a day.
You entered a long position at support and you don’t know where to take profits.
There are three possible Resistance levels, 30 pips away, 80 pips away and 200 pips away.
So, which one should you choose?
The target of 30 pips can be hit within a day, but exiting your trade at that point may deny you an opportunity to earn more profit.
Exiting a trade when it is too early denies you profit.
The reason is that the market is capable of moving 200 pips in a day.
It may be impossible to hit the 100 pips target within a day.
The reason is that it is far more than the ATR value.
So, an 80 pips target will be the best one for you as it is within your daily ATR value.
It also gives more profit than the 30 pips target.
Consider the following chart…
The above chart shows the three possible targets for taking profit.
The first target of 200 pips is unrealistic.
This is because there are very minimal chances of the market hitting that target.
So, you don’t have to set a profit target of 200 pips in this type of trade.
The second one, 80 pips, forms the ideal place for the profit target.
This is because it is within the range of the market which varies by 100 pips in a day.
The target of 30 pips is premature. The reason is that setting your profit target at that level may exit you out of trade when it’s too early.
This means that you will miss the potential of making profit.
So, to ensure you do it right, do the following…
- Determine the daily ATR value.
- When setting the profit target, combine it with the market structure and ensure that you set the profit target at a distance that is less than the daily ATR value.
A bonus tip for you is that if you trade longer-term, you can consider a weekly or monthly ATR value.
Here is a rule of thumb that you can apply in your trades…
If the Average True Range line is located in the upper half of the indicator, multiply the minimum potential of your pattern by 2.
It means that you can try and hit a target twice the usual for the pattern.
You can choose to use a scale out method or choose to exit the full position at the bigger target.
On the other hand, if the ATR line is located in the lower half of the indicator, you can choose to target only the minimum potential of the pattern.
The same idea also applies when the ATR line is trending steadily either upwards or downwards.
If you enter a trade in which the ATR is in the lower half with the line trending upwards, you can consider going with the double target option on the chart.
A good example is when the price breaks a triangle pattern in a bullish direction.
You may assume that the price will increase further, hence, you buy the Forex pair.
When trading a triangle pattern, you should stay in the market for a minimum price move that is equal to the size of the pattern.
However, if the ATR is giving high values at this time, you may choose to stay in the trade for a price move that is equal to twice the size of the triangle target.
You also have the option of exiting half of your position on the original target then close the other half at the second target.
How to Find “Exhaustion” Moves and Time Trend Reversals
There is nobody who can work forever nonstop.
Most of us get exhausted after an hour or so, hence, we take a break to recharge.
But why is this necessary?
It’s because the market behaves similarly.
The market cannot move for long without taking a break.
This means that there are high chances that the market will exhaust itself once it hits its limits.
So, how can you identify the limit?
I will tell you.
The solution is to use the Average True Range indicator.
- Determine the current ATR value.
- Multiple the value by 2.
- If the market moves 2 times the ATR value, there are high chances that it could be exhausted.
However, having said that, I don’t mean that you trade the above concept in isolation.
Instead, combine it with other market structures like Support and Resistance.
This way, you will be able to identify market reversals ahead of all other traders.
This is what you’ve learned…
- The Average True Range indicator measures the volatility of the market.
- Note that the indicator doesn’t tell traders about the direction of the market.
- A high value of the indicator is a signal that the market is highly volatile.
- A low value for the indicator is a signal that the market is less volatile.
- The direction of the indicator may contradict the direction of the market.
- You can use the indicator for a better management of your stop loss.
- The default value for the indicator considers a 14-period EMA. However, you can change this to the period that you want.