ATR Indicator: Measure Volatility
The market volatility is one of the key factors that determine the success of your trades. In times of high volatility, the risk of loss rises significantly. If you are a newbie, you should avoid periods of significant volatility because it becomes complicated to predict the market direction. Moreover, there are many issues with Stop Loss orders and Take Profit levels.
That’s why you need an instrument that will help you to place a good trade. There are many indicators that predict the market direction. Still, there are a few that can define the strength of market fluctuations. Average True Range is one of them.
Average True Range: What Is It?
ATR or Average True Range is an oscillator that determines the range of market volatility. It means the indicator shows the average size of the trade within a certain period of time.
ATR or Average True Range is an oscillator that determines the range of market volatility.
ATR was created by J. Welles Wilder Jr. and presented in his book "New Concepts in Technical Trading Systems." The Average True Range indicator is relatively young. It appeared in the book just in 1978. However, it’s widely used by traders all over the world.
As with any oscillator, the indicator's window is placed below the price chart. The Average True Range is presented by only one line that moves from bottom to top and back, showing the strength of market fluctuations.
The most significant feature of the indicator any trader should know is that it doesn't show the market direction. The increase of the ATR tool signals the rise in the market fluctuations. If the ATR falls, the range of the trades decline.
How to Place ATR in MetaTrader 4
The ATR indicator is set in MetaTrader by default. It means you don't have to download it from the Internet; you can quickly apply it to the chart. For that, click "Insert" in the upper tab, then "Indicators", choose "Oscillators," and "ATR" will be in the list.
Fortunately, for beginner traders, this indicator doesn't have many settings you have to deal with. There is only a period. The default period is 14, but you can change it according to your trading strategy.
The smaller period is, the more alerts the Average True Range provides. The more significant the period is, the fewer signals it will submit.
As with any other indicator, the shortage of the period will lead to a surge in the number of signals. Nevertheless, you should be ready that the risk of fake calls will rise as well. Inversely, if the period is more significant, the number of alerts will decrease. This will help you to filter signs if you are a newbie, but you may lose some effective entry points.
Why ATR Is Effective
The Average True Range is one of a few indicators that can define market volatility. It’s crucial for investors, especially for newbies. Volatility affects such important factors as Stop Loss orders, exit points, and the size of a trade. Thus, traders either avoid trading in times of significant volatility or prepare for it.
The Average True Range is an uncommon indicator, but it’s easy and provides simple signals any trader can read.
Moreover, the Average True Range tool is easy in usage as it has only one setting. Also, the ATR provides the signals any trader can read. One line and a lack of crosses allow traders to catch signals fast.
Although there are other tools that show the power of price fluctuations, the Average True Range is a default instrument on different trading platforms. To apply it to the chart, it requires just a few clicks.
ATR: Calculating an Indicator
As with any other indicators, the Average True Range is set automatically. This means that a trader won't have to do any calculations. Still, if you want a deep understanding of how the indicator works, you should learn how to calculate it. To measure the indicator, you need to consider the most recent high and low prices and the previous period's close price.
- Subtract the current period’s low price from the current period’s high price.
- Subtract the previous period's close price from the absolute value of the current high price.
- Subtract the last period's close rate from the absolute value of the current low price.
- To finish the calculation and define the ATR value, you need to compare three figures and choose the largest one.
ATR Tool: How to Read Signals
Although the Average True Range is used to determine the market volatility's strength, it also provides other alerts. Let's list them.
The primary function of the indicator is defining market volatility. As the Average True Range consists of one line, to determine the strength of the volatility, we need to set the barrier that will separate the high volatility from the low one.
To accomplish this, you can either draw a line by eye, in the middle of the range, or draw a moving average. Both will serve as an average line. If the indicator breaks above it, the volatility is high. If the ATR line is below the moving average or a middle line, the market is calm.
To set the moving average indicator, you can choose a significant period such as 100. The most crucial point here is to place the MA line not on the price chart but on the indicator. This function is available in MetaTrader.
Envelopes are also a way to confirm the power of market fluctuations. If you apply the Envelopes indicator on the ATR one, you can use Envelopes as the measure of the ATR movements. A break below the Envelope lines is a sign the market is calm. If the ATR is above the Envelopes, the candlesticks are big, so the volatility is high.
It seems strange, but the Average True Range instrument can also be used to clear the market trend. Above we said that the indicator determines when the market is calm and when there is a trend. So, when the indicator rises, it’s more likely that there is a trend formation. But if the ATR falls, the market consolidates.
The ATR can’t predict the direction of the trend, but can show its strength.
However, at the beginning of the article, we mentioned that the Average True Range is not an indicator that defines the market direction. That's why if you use it to decide where the market will move, you need to apply additional indicators that will confirm the market movements. We recommend using the trend indicators, such as Moving Average, Bollinger Bands, and MACD. Chart patterns can also be used to define the market trend.
Another option to confirm the current trend is to place ATR indicators on several timeframes. For instance, you can use the daily and hourly charts. If the instrument moves in the same direction on both timeframes and breaks the average line, it's a signal of the trend.
It's also possible to define if the market continues rising. In order to do this, you need to check the average of the daily move. If there is a note that the price has already passed or overcome the daily ATR movement, there is a chance that the market will fluctuate, but only if there is no significant news in the market.
Stop Loss Orders
The ATR indicator can also be used to place Stop Loss orders. No matter whether you trade in a calm market or you are willing to be risky enough to trade when the market fluctuates significantly, you should place Stop Loss orders correctly. The ATR indicator signals whether the order should be broad or narrow.
The ATR indicator is used to define entry and exit points. Nevertheless, it’s crucial to combine it with other tools to filter the signals.
You should remember that if you trade when the market is calm, the stop loss can be close to the entry point. However, if the market is volatile, you should increase the size of the order. Otherwise, there are risks you will exit the trade early.
To place a Stop Loss order, you need to calculate the value of the indicator when you enter the position. The Average True Range is represented in the way of 0.0000. For example, if it shows 0.0027, it means 27 pips. So, the stop loss order should equal 27 pips. It's also possible to place a stop loss that is 1 to 4 times bigger than the ATR value. If you use a trailing stop, you can set the double ATR value.
ATR: Benefits and Limitations
The ATR indicator has advantages and disadvantages. Knowing both sides of the technical instrument, you will learn how to implement it most effectively.
A small number of settings. It's a big advantage for beginner traders as they don't have to remember all of the specific settings.
Few timeframes. The ATR is effective only on timeframes bigger than H1.
Exclusive functions. There are a few indicators that can reflect market volatility.
No prediction. The Average True Range tool doesn't predict the market direction. The indicator reflects the strength of the volatility.
Multitask. Although, the Average True Range instrument is used to define the power of fluctuations, it can be applied for other aims. Stop Loss orders and trend direction can be predicted by the ATR.
Hardly read. It's not easy to read the signs the Average True Range provides. There is no average line that works as a barrier of two zones – low volatility and high volatility.
Easy to use. Although the indicator may provide unclear signals, it's widely used among traders due to its simplicity.
Forex Trading Examples with ATR
To make our explanation clearer, we need to make an example of ATR trading.
We place the ATR with the standard setting of 14. To define the middle line, we place the Moving Average on the ATR window. As soon as the Average True Range tool broke above the line, it meant the volatility rose. We see the confirmation because the candlesticks rose as well.
You may ask if I see that the candlesticks rise, why should I use the indicator. The indicator can be used to avoid trading. Also, you can increase the stop loss order knowing that the volatility increases.
The Most Effective ATR Strategies
As the ATR indicator is quite a complicated instrument, it’s tricky to include it in a trading strategy. That’s why we chose two effective strategies that will help you learn this tool better.
This strategy is based on increased volatility.
- Step 1. Choose an asset and a timeframe you want to trade. Remember, the indicator works better in high timeframes.
- Step 2. Place an indicator with a 20-period Exponential Moving Average.
- Step 3. We will trade on increased volatility. That’s why we should wait until the ATR line breaks above the Moving Average.
- Step 4. To get a confirmation of the increased volatility, you should check whether the price chart signals increased fluctuations. When the indicator breaks the EMA bottom-up, the current candlestick should surpass the previous one.
- Step 5. As soon as there is a candlestick confirmation of increased volatility, it’s time to enter a trade. It would be best if you opened a position on the opening price of the next candlestick formed after the one that confirmed increased volatility.
- Step 6. Trading on increased volatility, you should place a take profit order ahead. Previously, we stated that the Average True Range indicator can predict the size of the stop loss. Check the value of the ATR at the time when you open a trade. This figure will equal the number of pips you will probably earn. For instance, if the ATR is 0.0018, the Take Profit should be placed 18 pips from the entry point in the direction of the market direction.
- Step 7. To have a successful trade, it’s vital to place a stop loss order. The stop loss level should be located below the breakout candlestick - the one that confirmed the increased volatility.
This strategy works equally for both bearish and bullish trades. However, it’s vital to remember the indicator doesn’t predict the market direction; it shows the strength of the volatility.
The second strategy resembles the first one but includes some points that can be useful if the market conditions don’t fit those of the first one.
- Step 1. Choose the pair and a timeframe that suit your aims.
- Step 2. Set an ATR indicator. The middle line can be drawn by eye.
- Step 3. Wait until the indicator breaks above the middle line.
- Step 4. The price chart must confirm the continuation of the trend. Draw a resistance/support line regarding the trade you enter. If the candlestick breaks the line, you can enter the trade.
- Step 5. To define the Take Profit order, you should check the ATR value when you open a trade. It will be your first take profit level. It’s also possible to place the second take profit. For this, you can double the ATR value. If you remember, we mentioned that the stop loss order could equal 1-4 times the ATR value. The same rule applies to a take profit order.
- Step 6. To define a stop loss level, you should draw a support/resistance line regarding the trade direction before the breakout candlestick.
Just like the previous strategy, this one works both for buy and sell trades.
Tips for Traders
The ATR index is an uncommon technical tool. That's why investors make a lot of mistakes when implementing it:
- Wrong functions. Many traders forget that the indicator doesn't define the market's direction but is used to determine the strength of the volatility. So, if the indicator's line rises, it doesn't mean that the market is bullish. It just means that the volatility is high. If the indicator falls, it's a sign of market consolidation.
- Wrong timeframes. The indicator won't work effectively on small timeframes. It's recommended to use hourly periods.
- Wrong settings. Although the indicator has only one setting – it's a period, odds are there will be wrong numbers. If you place a small one, the number of fake signals will increase. If the period is too big, odds are you will miss a good point.
To conclude, the ATR indicator is among the few technical tools that measure market volatility. It's famous among investors due to its simplicity. Moreover, there are not many tools that can be easily set on any trading platform.
However, it's not always clear what the indicator alerts are about. That's why it's crucial to test its signals before entering the real market. For this aim, you can use a Libertex demo account. It includes not only standard currency pairs but also CFD assets. It's a great option to practice the indicator and learn how to trade different assets.
Why to trade with Libertex?
- access to a demo account free of charge
- technical assistance to the operator 5 days a week, 24 hours a day
- leverage up to 1:500 for professional clients
- operate on a platform for any device : Libertex and Metatrader 4 and 5
- no commissions for extractions in Latin America
Let's sum up and answer essential questions about the ATR tool.
How Do You Use the ATR Indicator?
The Average True Range indicator is used to determine the strength of market volatility.
How Do You Read an ATR Indicator?
If the indicator breaks above the average line, the market volatility is high. When the index falls, the market consolidates.
What Is an ATR Indicator?
The ATR indicator is an oscillator used not to define the market direction but the strength of its fluctuations.
How Do You Calculate ATR?
To calculate the indicator, you need to measure three figures. The largest one will be the ATR.