Average True Range bands - ATR bands Definition

The average true range (ATR) is a technical analysis indicator that measures market volatility
by decomposing the entire range of an asset price for that period. Specifically, ATR is a
measure of volatility introduced by market technician J. Welles Wilder Jr. in his book, "New
Concepts in Technical Trading Systems." The true range indicator is taken as the greatest of
the following: current high less the current low; the absolute value of the current high less the
previous close; and the absolute value of the current low less the previous close. The average
true range is then a moving average, generally using 14 days, of the true ranges.
What is Average True Range – ATR bands?
Average True Range is one of a number of technical analysis tools developed by Welles
Wilder. Some of the others include the Relative Strength Index, Average Directional Index
and the Parabolic SAR. ATR Bands focus on the degree of price volatility in a stock. They
can be used to time the entry into trades and help with setting volatility-based stop-losses.
True Range is calculated by looking at the daily price change and using the greatest of three
calculations: (high – previous close), (previous close – low) or (high – low). Average True
Range is the True Range calculation over a 5-day period average. ATR Bands take multiples
of the ATR - in this case a default multiple of 3 - and plot them as bands above and below the
ATR line.
Average True Range was introduced by J. Welles Wilder in his 1978 book New Concepts In
Technical Trading Systems. ATR is explained in greater detail at Average True Range.
Wilder developed trend-following Volatility Stops based on average true range, which
subsequently evolved into Average True Range Trailing Stops, but these have two major
weaknesses: Stops move downwards during an up-trend if Average True Range widens.
I am uncomfortable with this: stops should only move in the direction of the trend. The Stop-
and-Reverse mechanism assumes that you switch to a short position when stopped out of a
long position, and vice versa. All too frequently, traders are stopped out early when following
a trend and wish to re-enter in the same direction as their previous trade. Average True Range
Bands address both these weaknesses. Stops only move in the direction of the trend and do
not assume that the trend has reversed when price crosses the stop level. The Average True
Range (ATR) is an indicator used to measure price volatility. The creator J. Welles Wilder
created this indicator specifically for commodities in mind due to commodity prices are more
volatile than stocks, and that they are subject to price gap moves – a significant price
movement between two trading sessions. Although this is one of the indicators in Technical
Analysis, it is not a leading indicator to forecast trend direction but rather the ATR is used to
see how much raw movement there is in prices. In this manner, it reflects the interest or the
disinterest in price movements or price volatility. The frequently used ATR setting is 14 days.
The two rules you need to remember with ATR are as follows:
(a) When the prices are more volatile, the ATR moves up.
(b) When the prices are less volatile, the ATR moves down.

Key Takeaways
 Average true range (ATR) is a technical indicator measuring market volatility.
  It is typically derived from the 14-day moving average of a series of true range
indicators.
 It was originally developed for use in commodities markets, but has since been
applied to all types of securities.
 Average True Range Band Signals.

Signals are used for exits:

 Exit a long position when price crosses below the lower Average True Range Band.
 Exit a short position when price crosses above the upper Average True Range Band.
 While unconventional, the bands can be used to signal entries — when used in
conjunction with a trend filter. A cross of the opposite band can also be used as a
signal to protect your profits.
The Formula for ATR bands
The first step in calculating ATR is to find a series of true range values for a security. The
price range of an asset for a given trading day is simply its high minus its low. Meanwhile,
the true range is more encompassing and is defined as:
TR = max [(high - low), abs (high - close previous), abs (low - close previous)]
Where:
TRi = a particular true range; and
n = the time period employed (which is usually 14 days).
Average True Range Bands Formula
Here is a brief outline:
Average True Range is calculated in accordance with J. Welles Wilder's formula.
The bands are calculated by adding/subtracting a multiple of Average True Range to the daily
closing price.
For the High Low option, the multiple of ATR is added to the daily Low, and subtracted from
the daily High.
A ratchet mechanism ensures that the lower band only moves up in an up-trend and the upper
band only moves down in a down-trend.
Plots are projected one day forward (e.g. the stop caculated from today's closing price is
plotted for tomorrow)
What Does Average bands INDICATE
Wilder originally developed the average true range (ATR) for commodities, but 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 it is a useful tool 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 fairly simple to calculate and only needs historical price data. The use of 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 places a trailing stop under the highest high the stock reached
since you entered the trade. The distance between the highest high and the stop level is
defined as some multiple times the ATR. For example, we can subtract three times the value
of the ATR from the highest high since we entered the trade. Average true range can also
give a trader an indication of what size trade to put on in derivatives markets. It is possible to
use the ATR approach to position sizing that accounts for an individual trader's own
willingness to accept risk as well as the volatility of the underlying market. (For a detailed
example on how to use ATR for this purpose, read our article, Sizing A Futures Trade Using
Average True Range.)
Limitations of ATR bands
There are two main limitations to using the average true range indicator. The first is that
ATR is a subjective measure - meaning that it is open to interpretation. There is no single
ATR value that will tell you with any certainty that a trend is about to reverse or not. Instead,
ATR readings should always be compared against earlier readings to get a feel of a trend's
strength or weakness. Second, ATR also only measures volatility and not the direction of an
asset's price. This can sometimes result in mixed signals, particularly when markets are
experiencing pivots or when trends are at turning points. For instance, a sudden increase in
the ATR following a large move counter to the prevailing trend may lead some traders think
the ATR is confirming the old trend; however, this may not actually be the case.
How to Use Average True Range (ATR) Indicator for Optimal Results
There are several different class of indicators that a trader can utilize. And based on the
specific goal, such indicators can help in the overall decision-making process. Most traders
are familiar with momentum based indicators such as RSI and Stochastics. But there are also
other types of indicators that are based on volume, volatility, cycles, or some other measure.
In this lesson, we will discuss a specific trading indicator that measures the volatility of a
currency pair. It is called the Average True Range indicator, commonly referred to as ATR.
The Average True Range is a single line indicator that measures volatility. The indicator was
originally developed by J. Welles Wilder to measure the volatility of commodities within the
futures market. ATR does not measure price trends or price direction like other common
indicators like the MACD or the Momentum indicator. Instead, the ATR indicator simply
shows when volatility is high and when it is low. This is an enlarged view of the ATR
Indicator, which is usually attached in a separate window to the bottom of your chart. The
single line of the ATR indicator fluctuates within a range. High prints of the ATR line
indicate that the market is experiencing high price volatility. On the other hand, depressed
ATR levels imply that the price volatility within the market is relatively low. Traders can use
the prints of the ATR line to consider entry and exit points based on price volatility. When
volatility is high, Forex pairs are likely to be dynamic and faster moving. In contrast, low
volatility is associated with a quiet market or consolidation period. Although the ATR
indicator is not as widely used by retail traders as some othermomentum based indicators, it
serves an important purpose for volatility conscious traders who are interested in gauging the
current level of volatility or trying to anticipate potential price breakouts. Experienced traders
are aware that markets move from periods of low volatility to high volatility and back again
constantly. As such, the ATR is an invaluable trading tool for those that can appreciate this
ebb and flow within the market.
ATR Volatility Analysis
As we touched upon earlier, the ATR indicator can be used to perform volatility analysis on
the chart. The Average True Range tells you when volatility is high and when it is low. One
of the best applications of the ATR volatility indicator is that it can help you to place your
stop loss order in a manner which is consistent with current market conditions. Basically, it
will help you to avoid placing stops too tight during high volatility periods and placing stops
to wide in low volatility periods. In addition, it can assist you in setting higher probability
take profit points. For example, If the ATR has a relatively high reading, you might consider
staying in the trade for a bigger target on the expectation that the increased volatility can lead
to a larger favorable price move.
In the example above you see the EUR/USD chart for February 2016 – February 2017 with
an ATR indicator attached at the bottom. The red arrows on the ATR indicator point to times
when the values are relatively high, which is associated with high price volatility. Notice, the
large volatile candles on the upper price chart at these corresponding times Contrary to this,
when the ATR readings are low, the market is relatively quiet as it has entered a period of
low volatility. Candles are small, price action is calm, and the EUR/USD is consolidating
rather than moving directionally. When the volatility is low, you can adjust your Stop Loss
orders tighter. At the same time, your targets should be smaller as well, since the price is not
expected to move much. The ATR indicator can also be used to project future tendencies. If
you notice that the ATR line is steadily trending upwards, then you can assume that volatility
is likely to remain high. And for a steady down sloping ATR, we can expect continued range-
bound type environment in the near future. At the same time, you should be on the lookout
for a transition from low to high volatility or high to low volatility to prepare you for a
change in market condition.

MT4 ATR Indicator

The ATR indicator is built into the MetaTrader 4 trading platform – the most commonly used
Forex trading terminal. To activate the MT4 ATR indicator you should simply go to Insert >
Indicators and choose Average True Range. The indicator then attaches to your chart with its
default average setting – 14-period Exponential Moving Average. If you want to change this
setting, you should simply drag the mouse cursor to the indicator at the bottom of your chart
and click the right mouse button. Then you would choose “ATR(14) Properties…”, which
will bring up the following pop-up window:
Then under the “Parameters” tab, you will see a field named “Period.” Simply change the
default “14” value to your preferred setting. The new settings of the MT4 ATR indicator will
be applied automatically.
Practical Application of Average True Range
Since ATR is primarily a price volatility study, it cannot be used as a standalone tool for
trading the market. You will use it in combination with your trading methodology to fine tune
your entry, stop loss placement, and profit target. One of the most effective ATR strategies is
one that includes price action analysis and a Trailing Stop Loss order based on an ATR value.
You can use price action patterns as entry signals on the chart. These could be chart patterns,
candle patterns, trend lines, trend channels, etc.
Stop Loss Placement
One you have entered into a trade, you can use an ATR based trailing stop. The point is to
use the value from the Average True Range indicator to determine the distance you want to
trail the price. When the price action moves in your favor afterward, the stop loss will also
move along with price taking into account the distance you have set from the current price.
But, if the price action moves contrary to your trade, the ATR Trailing Stop will stay still. As
such, an ATR trailing stop will help provide for a looser stop as prices moves in the direction
of your trade, allowing you to extract the maximum amount from the market when there is
a persistent trend. There is a simple rule to determine a Stop Loss within an ATR trade
management approach. If the ATR indicator line is in the upper half of the area, you can
consider the currency pair as relatively volatile, putting a looser Stop Loss order in the
market. If the ATR is giving a value that is located in the lower half of the indicator, then you
can use a tighter Stop Loss order, since the price is relatively less volatile than normal.
Setting a Target
Now we will discuss some simple guidelines for managing your exit using the ATR indictor.
If the ATR line is in the upper half of the indicator during your trade, you can consider
multiplying the minimum potential of your pattern by 2. This means that you can try and hit a
target twice the usual for the pattern. You may want to use a scale out method when doing
this or decide to exit the full position at the bigger target. On the other hand, if the ATR line
is in the lower half of the indicator, then you may want to only target the minimum potential
of the pattern. The same idea is in force if the ATR line is steadily trending upward or
downward. If you enter a trade where the ATR is in the lower half, but the line is trending
upward, you can still consider the double target option on the chart. Let’s say the price breaks
a triangle pattern in the bullish direction. As a result, you decide to buy the respective Forex
pair on the assumption that the price is increasing. The triangle pattern rules state that you
should stay in the market for a minimum price move equal to the size of the pattern.
However, if the ATR is giving you high values at this time, you may consider staying in the
trade for a price move equal to twice the size of the triangle target. As an option you could
exit half your position on the original target and close the other half at the second target. In
some cases, the patterns or trade setups may not have a calculated target. This is when the
ATR Trailing Stop comes into play. With this, you would simply hold the trade as the price is
trending in your favor and exit when the Trailing Stop Loss order gets hit.
Example of Trading with ATR and Price Action
Now let’s take a look at an ATR based trade management strategy in action.

We are now looking at the H1 chart of the GBP/USD Forex pair for July 5-14, 2016. The
image shows an example of an ATR trading strategy where a long trade is opened when a
bullish breakout occurs through the upper level of a range. Notice that we have marked the
middle level of the ATR indicator at 0.0039 in order to bisect the upper and the lower part of
the indicator. The blue horizontal lines on the price chart mark the range of the GBP/USD.
The blue horizontal line in the ATR area shows the ATR line at the middle level. Notice that
the ATR line breaks the middle level and shifts into the upper half of the indicator. However,
the price is still located in the horizontal channel. Later, the price breaks the range through
the upper level, giving us a long signal. The ATR line is in the lower half of the indicator at
this moment. Therefore, you could buy the GBP/USD with the initial idea that you will
pursue the minimum target of the pattern equal to the size of the range.
But on the way up we see that the ATR line starts trending upward. At the same time, we see
that the line moves in the upper half of the indicator a few times. This gives sufficient reason
to believe that the GBP/USD volatility is increasing. Therefore, you have the option to extend
your target by using the x2 rule. You should also adjust your ATR Trailing Stop Loss as
shown on the image. Then you could hold the trade until the price reaches 2x the size of the
range, shown with the two magenta lines. The first red arrow indicates the distance between
the adjusted Trailing Stop and the entry price. The GBP/USD price decreases by this level
right after the 2x target is reached on the chart. The second arrow you see at the end of the
chart shows the moment when the price would have hit the ATR Trailing Stop if you had not
already closed the trade.
Let’s see the power of the ATR Trailing Stop with another example.

This time we have the H4 chart of the EUR/USD for May – June 2015 where we give an
example of a closed trade using the ATR Trailing Stop. The chart begins with a bearish
channel. Suddenly, the price of the EUR/USD breaks the bearish channel through the upper
level during relatively low ATR prints. You could buy the EUR/USD at this moment, placing
a Trailing Stop Loss order under the previous bottom on the chart as shown on the image –
about 90 pips distance. The price tests the already broken upper channel level and bounces
upward on sharply increasing ATR values. As such you could adjust the distance of your
Trailing Stop to contain the volatile price action in a better way. You could measure the
distance between the breakout point and the low of the previous bearish channel and apply
the parameter as a new pip distance for your Trailing Stop Loss – about 140 pips. The price
action creates a couple of strong bullish impulses before hitting the Trailing Stop. See that
after the first impulse the price creates a correction that nearly hits the Trailing Stop (red
arrows). However, the Stop Loss order is well positioned, and it sustains the pressure. If you
haven’t adjusted the distance of the Trailing Stop on the volatility increase, the Stop would
have been hit, putting you in a position to likely miss the next sharp impulse. After the
second impulse, the price action starts a general consolidation where the Trailing Stop
eventually gets hit. This is a channel breakout trade which has no specific target rules. This is
when the Trailing Stop comes in most handy. Also, there are cases when you want to scale
out rather than go for the full target, which is another case when the Trailing Stop can be
useful. Just don’t forget to loosen and tighten the ATR Trailing Stop based on values shown
on the ATR indicator.
Conclusion
 ATR stands for Average True Range. It was developed by a famous technical analyst
named J. Welles Wilder
 The ATR is an indicator that measures price volatility, originally designed for
commodity trading.
 High ATR values indicate high volatility. Low ATR values imply that volatility is
relatively low.
 The indicator consists of a single line that fluctuates around a range.
 The ATR Calculation is as follows:
 The Average True Range formula involves the initial calculation of the True Range
on the chart, where you should take the highest value of these three formulas:
 (High of the Current Period) – (Low of the Current Period)
 (Current Period High Absolute Value) – (Close of Previous Period)
 (Current Period Low Absolute Value) – (Close of Previous Period)
 Then you plot an Exponential Moving Average to get the Average True Range.
 Using ATR in trade management allows you to set better Stop Loss orders and
targets:
 When ATR indicator is high, volatility is high:
 Set looser Stop Loss orders.
 Set bigger targets.
 When ATR indicator is low, volatility is low:
 Set tighter Stop Loss orders.
 Set smaller targets.
 You can find a built in ATR indicator in the MetaTrader4 platform:
Insert>Indicators>Average True Range
 The default ATR value takes into consideration a 14 period EMA. To change the
value of the MT4 ATR indicator you should:
 Right-click the indicator at the bottom of your chart.
 Choose “ATR(14) Properties…”
 Click on “”
 In the “Period” field replace the default “14” by the period you want to include.
 An ATR strategy could combine price action analysis and a Trailing Stop:
 Open trades based on price action events or patterns.
 Set a tight Trailing Stop if the ATR shows lower values. Set a loose Trailing Stop if
the ATR shows higher values.
 If a chart pattern has a certain target:
 On lower ATR values hold the trade until the minimum pattern potential is acheived.
 On higher ATR values hold the trade for 2x the minimum pattern potential and
consider scaling out half at 1X target and half at 2X target.
 If the pattern has no specific target rules:
 Hold the trade until the Trailing Stop is hit.
 Note that the Trailing Stop based on an ATR value could be adjusted periodically as
needed based on market conditions.