One of the best-known technical analysts to first write in detail about using volatility as a trading indicator was J. Welles Wilder. In his 1978 book ‘New Concepts in Technical Trading,’ he introduced many cornerstones of modern technical analysis, including the Relative Strength Index (RSI), the Parabolic SAR Indicator (PSAR), and the Average True Range Indicator (or ATR indicator). But what is the average true range?
This article will explain the average true range indicator, what it measures, and how to use the ATR Indicator in trading.
The average true range indicator measures volatility within the market. But how does the ATR indicator achieve this?
Wilder developed his indicators while looking at the commodity markets and realised that measuring volatility by solely looking at the day’s trading range was too simplistic. Instead, he determined that to provide an accurate figure for volatility within a time, the previous session’s close needed to be considered together with the current high and low.
Thus, he defined the true range as being the greatest out of the three following values:
Wilder then proposed taking an average of this figure over multiple days to produce a meaningful representation of volatility. Logically enough, he called this the average true range.
Essentially, the average true range is a moving average of the true range over a predetermined time.
Fortunately, traders who use MT4 or MT5 will not have to worry about calculating the average true range formula because both trading platforms will do it for you instantly.
Traders can generate more trading signals in shorter periods than 14 days, while more extended periods are more likely to generate fewer trading signals.
For example, assume a short-term trader only wishes to analyse a stock’s volatility over five trading days. Therefore, the trader could calculate the five-day ATR.
Assuming the historical price data is arranged in reverse chronological order, the trader finds the maximum of the absolute value of the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close.
These calculations of the true range are done for the five most recent trading days and are then averaged to calculate the first value of the five-day ATR.
Wilder originally developed the ATR for commodities, although the indicator can also be used for stocks and indices.
Simply put, a stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR.
The ATR may be used by market technicians to enter and exit trades and is a handy feature to add to a trading system. It was created to allow traders to more accurately measure the daily volatility of an asset by using simple calculations.
The indicator does not indicate the price direction; rather, it is used primarily to measure volatility caused by gaps and limit up or down moves. The ATR is a basic calculation that requires only past price data.
The ATR is commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the “chandelier exit” and was developed by Chuck LeBeau.
The chandelier exit sets a trailing stop under the highest high the stock attained since you entered the trade. The distance between the highest high and the stop level is multiple times the ATR.
For example, we can subtract the ATR value three times from the highest high since we entered the trade.
As previously stated, the average true range indicator measures market volatility. Traders frequently misinterpret what this means, mistaking volatility for momentum.
Volatility, unlike momentum, does not reveal anything about the strength or direction of a trend. Instead, it tells us how much the price varies around the average price.
So, what is average true range used for in trading?
The ATR indicator is frequently used to assist traders in placing stop loss orders. For example, if the average true range indicator indicates that current volatility levels are low, traders may choose to place a tighter stop loss.
When volatility is high, traders may consider placing stop losses further away from their entry-level. This is because traders expect more significant price movements when volatility is high. As a result, a stop loss that is too tight in a volatile market may be activated prematurely.
As a hypothetical example, assume the first value of the five-day ATR is calculated at 1.41, and the sixth day has a true range of 1.09. The sequential ATR value can be calculated by multiplying the previous ATR value by the number of days less than one, then adding the true range for the current period to the product.
Then, divide the total by the timeframe you’ve chosen. For example, the second value of the ATR is estimated to be 1.35, or (1.41 * (5 – 1) + (1.09)) / 5. The formula could then be repeated over the entire time.
While the ATR does not indicate which direction the breakout will occur, it can be added to the closing price and used to buy whenever the next day’s price trades above that value. This idea is shown below. Trading signals occur relatively infrequently but usually spot significant breakout points.
The logic behind these signals is that whenever a price closes more than an ATR above the most recent close, volatility changes. Taking a long position is betting the stock will follow through in the upward direction.
When you use the ATR on an intraday chart, such as a one- or five-minute chart, the ATR will spike higher right after the market starts, probably right after the major U.S. exchanges open at 9:30 a.m. The ATR moves throughout the first minute of ET. This is because the open is the most volatile time of day, and the ATR merely reflects that volatility is higher than it was at the previous day’s close.
After the initial spike, the ATR typically declines for the rest of the day.
Day traders can use the one-minute ATR in the same manner that they use the daily ATR to anticipate how much an asset will move in five or ten minutes. This strategy can aid in the establishment of profit targets or stop-loss orders.
A trailing stop-loss is a technique to quit a trade if the asset price moves against you, but it also allows you to alter the exit point if the price moves in your favour. Many day traders use the ATR to determine where to place their trailing stop-loss.
Look at the current ATR reading at the time of a trade. To determine a realistic stop-loss point, multiply the ATR by two. If you’re buying a stock, you may set a stop-loss at twice the ATR below the entry price. If you’re shorting a stock, you’d set your stop-loss at twice the ATR above the entry price.
If you’re long and the price moves in your favour, keep moving the stop-loss to twice the ATR below the price. In this case, the stop-loss is always raised, never lowered. Once pushed up, it remains until it can be moved up again, or the trade is stopped due to the price falling to the trailing stop-loss level. The identical approach works for short trades, only that the stop-loss only moves downward.
Assume you enter a long trade at $10 with an ATR of $0.10. You would place your stop-loss at $9.80 (2 * $0.10 less than $10). The price climbs to $10.20, but the ATR continues at $0.10. The trailing stop-loss has been raised to $10. When the price rises to $10.50, the stop-loss rises to $10.30, locking in at least a 30-cent profit on the trade. This would continue until the price fell below the stop-loss point.
The average true range indicator comes with the standard package of indicators available when you install MT4 and MT5, meaning that you will not have to perform a separate ATR indicator download.
The average true range indicator can be found in MetaTrader 4 and MetaTrader 5 in the ‘Indicators’ section of the ‘Navigator’ window on the left-hand side of the screen.
When you add the average true range indicator to your price chart, you will be presented with the ATR indicator settings window. The only variable you must worry about is the ‘Period.’
This is the number of periods over which MT4 or MT5 will make the average true range calculation. Above the ATR indicator settings, the default value in MT4 and MT5 is 14, which is a suitable starting place for traders. Once you’ve mastered the ATR indicator, you might want to experiment with different periods to see what works best for you.
After you click ‘OK,’ a graph displaying the average true range indicator will appear beneath your main price chart.
The peaks on the ATR indicator chart indicate more volatile trading times, while the troughs represent less volatile times. Hovering your cursor over the line chart will show you the exact value of the average true range.
Traders can exit these trades by producing signals based on subtracting the ATR value from the closing. The same rationale applies to this rule: anytime the price closes more than one ATR below the most recent close, there has been a major change in the market’s character. Closing a long position becomes a safe decision since the stock will likely enter a trading range or reverse direction.
The ATR is most typically employed as an exit technique that may be used regardless of the entry choice. Chuck LeBeau invented one common technique known as the chandelier escape. The chandelier exit establishes a trailing stop below the stock’s highest high since you started the transaction.
Price action trading - Price speaks louder than words — 2023The distance between the highest high and the stop level is determined by multiplying the ATR by a multiple. For example, we can remove the ATR value three times from the highest high since we started the trade.
The value of this trailing stop is that it swiftly rises upward in reaction to the market action. “Just like a chandelier hangs down from the roof of a home, the chandelier exit hangs down from the high point or ceiling of our trade,” LeBeau explained.
ATRs are better than fixed percentages in some ways because they change based on the characteristics of the stock being traded, recognising that volatility varies across issues and market conditions.
The distance between the stop and the closing price automatically adjusts and moves to a suitable level when the trading range grows or reduces, combining the trader’s desire to safeguard gains with the requirement of allowing the stock to move within its normal range.
Strategies of any time range can leverage ATR breakout systems. They are particularly beneficial as day trading strategies.
Day traders use 15 minutes to add and subtract the ATR from the closing price of the first 15-minute bar. This gives entry opportunities for the day, with stops set to complete the trade at a loss if prices return to the closing of the day’s first bar. Any time limit, such as five or ten minutes, can be used.
For example, a 10-period ATR that incorporates data from the prior day might be used in this strategy. Another option is to employ numerous ATRs, ranging from a fraction, such as half, to as many as three. (Beyond that, there are too few transactions to make the strategy lucrative.)
Toby Crabel proved that this technique works on a range of commodities and financial futures in his 1990 book, “Day Trading With Short-Term Price Patterns and Opening Range Breakout.”
Some traders adopt the filtered wave methodology to identify market turning points and use ATRs instead of percentage moves. A new up wave begins when prices move three ATRs away from the lowest closure. A new down wave begins if the price goes three ATRs below the highest closure since the commencement of the up wave.
There are two main drawbacks to using the ATR indicator. The first is that ATR is a subjective measure, which means it can be interpreted in several ways. No single ATR value can tell you whether or not a trend is about to reverse. Instead, ATR data should always be compared to previous readings to determine the strength or weakness of a trend.
Second, ATR measures volatility, not the price direction of an item. This may occasionally result in confusing signals, especially when markets are pivoting or trends are at a turning point. For example, a sudden increase in the ATR following a large move against the current trend may lead some traders to believe that the ATR is confirming the old trend; however, this may not be the case.
The ATR indicator was initially designed for commodities. Still, it is widely used in both the stock and forex markets and is one of the most popular volatility indicators available.
Because the average true range indicator does not assess the direction and only analyses the magnitude of the range, it has limited utility as a tool for generating trading signals. It is a valuable tool for estimating how much a market may move. This, in turn, influences crucial trading decisions such as stop-loss placement.
The standard number of employing with an ATR indicator is 14; however, it isn’t the only strategy that works. If you wish to pay more attention to recent volatility levels, choose a lower number. Long-term investors may use a more significant number to take a broader evaluation.
