What is the average true range indicator?

In this lesson, we explore the average true range indicator (ATR), how to calculate it and what it's got to do with turtles (it will make sense when we get there!).

What is the average true range (ATR) indicator?

The average true range (ATR) is a powerful technical analysis tool that measures market volatility — essentially, how much an asset's price moves over a given period.

Unlike other indicators that focus on price direction, the ATR focuses exclusively on measuring price volatility, making it an essential component of many traders' risk management strategies. The ATR indicator adapts to different market conditions and timeframes, providing valuable insights across various financial markets, including forex, stocks, indices, and commodities.

Traders use the ATR to help them make more informed decisions about position sizing and stop-loss placement. The ATR rises or falls according to whether an asset's price movements are becoming more or less dramatic — a higher ATR value represents greater market volatility, while a lower ATR suggests the opposite.

What has this got to do with turtles?

In 1983, legendary commodity traders Richard Dennis and William Eckhardt conducted the famous "Turtle Traders" experiment to settle a debate: could anyone be taught to trade successfully, or was it an innate talent?

Dennis looked for traders with little to no experience in the market and gave them a set of mechanical technical rules to trade with, along with some money management techniques. He selected a group of those who proved that they had the discipline to follow his rules and gave them his own capital – ranging from $500,000 to $2 million.

The results were impressive. Over four years, the turtle traders achieved compound annual returns exceeding 80%. When asked about the key to their success, Dennis emphasised that it wasn't about timing entries and exits, but about understanding market volatility and managing risk accordingly.

He called his students "turtles" after the turtle farms he had visited in Singapore. The idea was that he could grow traders as successfully as farm-grown turtles.

Why are we telling you this? Because the story illustrates a crucial trading principle: understanding market volatility is more important than perfect timing. And the ATR indicator is one of the most effective tools for measuring and analysing that volatility.

Calculating the ATR

The ATR indicator provides a single number representing the average range of price movement over a specified period. While modern trading platforms like IG calculate the ATR automatically, understanding the process helps you interpret the indicator more effectively.

The calculation of the ATR involves three steps:

Step 1: Calculate the True Range (TR)

For each period, the True Range is the greatest of these three values:

• Current high minus the current low
• Absolute value of the current high minus the previous close
• Absolute value of the previous close minus the current low

Step 2: Determine the lookback period

Typically, traders use a 14-period ATR, meaning they collect 14 ATR values, but you can adjust this based on your needs.

• Shorter timeframes (hours, for example): 2-10 periods are recommended
• Longer timeframes (weeks or months): 20-50 periods are recommended

Step 3: Calculate the moving average

The final step is to calculate the average of these TR values, using two methods.

Initial calculation: Take a simple average of your first 14 TR values (or whatever period you've chosen).

Ongoing calculation: Use the exponential moving average formula:

New ATR = (Previous ATR × 13 + Current TR) ÷ 14

Most modern trading platforms, including IG, use this exponential moving average (EMA) approach because it's more responsive to recent price movements while still smoothing out the indicator. The multiplier of 13 comes from the standard EMA smoothing factor for a 14-period calculation.

Interpreting the ATR

Higher ATR values indicate increased volatility, suggesting that prices are moving more dramatically. Conversely, lower ATR values suggest decreased volatility and more stable price action. ATR values tend to be higher for more volatile assets and lower for less volatile ones. For example, if an asset's ATR remains below 1 and moves within a narrow band (say, between 0.81 and 0.90), this suggests relatively stable price action with low volatility.

Tip: Traders should pay attention to sudden increases in the ATR, as these can signal potential breakouts or trend reversals. Such changes in volatility often precede significant price movements, making them valuable for both entry and exit decisions. Learn more about trading volatile markets.

Using the ATR

The adaptability of the ATR makes it a valuable tool for managing risk in different market environments. Because it responds to changes in volatility, traders can use it systematically and consistently across different market conditions.

Incorporating the ATR into a trading strategy can help traders limit emotional decisions, adjust risk management to suit their trading style or risk tolerance, respond better to shifting market conditions, and trade more consistently overall.

That said, it's important to remember that the ATR is a lagging indicator based on past price data. It should be combined with other technical and fundamental tools for a well-rounded trading approach.

Let's look at two practical ways you might use the ATR: setting stop-losses and position sizing.

Setting stop-losses

One of the primary applications of the ATR indicator is setting stop-loss orders that account for an asset's natural price fluctuations. This approach helps traders avoid being stopped out by routine volatility while still protecting their positions.

To set a stop-loss using the ATR, traders typically use the following formulas:

• For long positions: Stop-Loss = Entry Price - (ATR * Multiplier)
• For short positions: Stop-Loss = Entry Price + (ATR * Multiplier)

Tip: The multiplier is a personal choice based on risk tolerance, with common values ranging from 1.5 to 3. For example, if you're long on a stock trading at $25 with a 14-day ATR of $0.80, and choose a multiplier of 2, your stop-loss would be: $25 - ($0.80 × 2) = $23.40.

This method adapts the stop-loss to the asset's volatility, offering wider stops during volatile periods and tighter stops during calmer markets. Traders can practise setting these stop-losses using a demo account before applying them to live trades.

In particularly volatile markets, you might want to implement a trailing stop at a certain number of points behind the current market price. The ATR indicator can help you do this by showing when volatility is rising or falling. You might want to reduce or increase the level at which you have placed a trailing stop to secure your profit while also protecting against potential heavy losses.

Alternatively, you might want to put a guaranteed stop on a position if you want to close out any possible losses at a specified and certain level. Remember, however, that a guaranteed stop will incur a cost if it is triggered.

Position sizing

The ATR indicator is also valuable for determining position sizes, helping ensure trades align with your risk tolerance. Here's a step-by-step method for using ATR in position sizing:

1. Determine the cash amount you're willing to risk per trade
2. Calculate the per-unit risk based on the ATR
3. Divide your cash risk by the per-unit risk

In the next lesson, we look at chart patterns, beginning with the head and shoulders chart.