Trading with the average true range indicator
The average true range (ATR) indicator is a technical indicator that was first described in 1978 by famous technical analyst J. Welles Wilder Jr. Here, we explain how the ATR works and how to use it in your trading.
What is the average true range indicator?
The average true range (ATR) indicator is one of a number of popular trading indicators, and it is used to track volatility in a given time period. It moves up or down according to whether an asset’s price movements are becoming more or less dramatic – with a higher ATR value representing greater volatility in the underlying market, and a lower ATR representing the opposite.
You can use the ATR to establish where to place a stop or limit order, as well as when you might want to open or close a trade. This is because, by tracking volatility in a given time frame, ATR shows when price movements might become more or less sporadic as volatility increases or decreases.
How does the ATR work?
The ATR works by creating an average of the true range, which is the classic measurement of the range of movement in an asset’s price. The average true range, in contrast, is a smoothed moving average of the true range values, which seeks to make assessing an asset’s volatility easier and more accessible for traders.
ATR was originally developed for the commodities market, but it can also be applied to forex, stocks and indices. It relies exclusively on historical price action data, but it does not itself show price movements.
The price chart below shows the ATR for the FTSE 100 over an eight-month period in 2019. Eight months is a particularly long time frame to use for ATR, but it illustrates how the indicator tracks volatility clearly for the purpose of this example.
The ATR is the blue line underneath the candlestick chart, and it shows that the price of the FTSE 100 became more volatile around late July – because the ATR chart spikes upward as the price of the FTSE 100 falls.
How to calculate the average true range
To calculate the average true range, you would first need to calculate the true range. You would do this by taking the largest of these three calculations:
- The current high minus the previous close
- The current low minus the previous close
- The current high minus the current low
You would repeat this throughout a specific time frame to achieve a moving average of a series of true ranges. A 14-period moving average is recommended as a basis from which to work out the average true range, usually over a 10- to 14-day period. For shorter time frames – hours for example – it’s recommended to use between two to 10 periods; for longer time frames – weeks or months – 20 to 50 periods are recommended.
For the table below, the figures have been used to calculate a 14-day ATR over a 10-day period. The true range for each day was calculated as described in the bullet points above.
The first true range value – taken for 1 August – is simply the current high minus the current low because the previous close cannot be used, and the first average true range – taken for 14 August – is an average of the 14 previous true ranges. After that, to achieve each subsequent average true range you would multiply the previous 14-day ATR by 13, add the most recent day’s true range and then divide the result by 14.
|High||Low||Close||True range||Average true range|
From the ATR calculation, a trader can tell whether an asset is experiencing greater or lower volatility in a particular trading session. For this particular asset, the ATR remained below 1, and it moved within a narrow band of between 0.81 and 0.90 – meaning that it wasn’t experiencing high levels of volatility. As a result, this asset might be an attractive option for a trader who doesn’t have a large appetite for risk.
How to use the average true range indicator in your trading
In a particularly volatile market, you might want to implement a trailing stop at a certain amount of points behind the current market price. This will help to lock in profit while also protecting against negative movements if an asset’s price is unpredictable.
The ATR indicator can help you do this by showing when volatility is rising or falling. If this is the case, 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. However, a guaranteed stop will incur a premium if it is triggered.
While the ATR is a useful tool for assessing volatility levels, it should be used alongside other technical indicators to confirm your decisions about whether to open or close a position. Other indicators that can help assess volatility levels include Bollinger bands and Keltner channels.
Several online trading platforms have a function to overlay the ATR onto trading charts. These include the IG online trading platform and MetaTrader 4 (MT4) – a popular platform for algorithmic trading. This makes it easy to track volatility in an underlying market without having to calculate the average true range manually.
Summing up the ATR
- ATR is a smoothed moving average of volatility over a given time frame
- It can be used on the forex, index, stock and commodity markets
- A 14-day moving average is the recommended basis for the average true range, but other periods can be used for shorter or longer timeframes
- ATR is often used for assessing when and where to enter or exit a position, as well as at what price level to implement a trailing or guaranteed stop
- However, while ATR is useful in these respects, you should use it in conjunction with other indicators to confirm forecasts
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