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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.
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.