Today I am going to focus on the ATR indicator (average true range indicator).
By now you know I am not a very big fan of indicators, but the average true range indicator is one of the best indicators out there.
If I was to use indicators in my trading, it’s only the ATR and moving averages that would appear on my charts.
The reason why I discourage the use of indicators, more so, for beginners in forex trading is due to over-reliance that comes with their use.
Traders start using indicators, and all they are looking for is a sell or buy signal. This is based on the information that they are deriving from the indicators.
This is not a good practice in trading since you are denied the chance of ever knowing how the market operates. You should have the knowledge as to why an indicator is giving a sell or a buy signal.
This is a skill that you can only acquire by observing and analyzing naked charts using price action trading strategies.
Indicators should only be used for confirmation purposes after you have already analyzed the market.
By doing this, you will be able to know
- The areas of value in the chart
- Where many traders are likely to be trapped
- Areas where new players are likely to enter
- The inherent path of least resistance
- Areas where losers are likely to cut losses
- What traders in the sideline are thinking
This is the psychological part of trading. This is where you lose money that you could have easily gained.
Being aware of such instances is likely to have a big positive impact on your trading endeavors.
How many times has your stop-loss been triggered then the market moves in the direction that you had anticipated? A lot, right?
This is because the big banks understand the psychology of most traders and the tools that you are using to trade.
Imagine if you had the same understanding, and you are able to decipher some of the trading traps when you are analyzing the market?
The reason why I like the ATR indicator is that it is different from most indicators. The average true range indicator does not focus on the trend or momentum of the market, like most indicators do.
What is the ATR Indicator?
The ATR indicator is among the most common and most used technical analysis indicators.
ATR is used in tracking volatility in a specific market.
Contrary to many other technical indicators, the average true range indicator does not show the price trend of the market, and it only measures the market’s volatility.
ATR was developed by Wilder. While establishing his indicators, J. Welles Wilder discovered that purely focusing on the daily range was quite simplistic as a volatility measure, due to the way commodities often go limit up or limit down, or difference in price from the close of the day before to the new opening.
His great discovery was an indication that to effectively show the true volatility of the market there was a need for him to consider the previous day’s close and the current high and low.
From this discovery, Wilder then defined the actual range as the greatest of the following three values:
- The distance between the previous close and the current low
- The distance between the previous close and the current high
- The distance between the current high and the current low
He later suggested taking an average of this value for some days so as to give a better representation of volatility.
He then called this the Average True Range.
Volatility vs. Momentum
The ATR indicator is used in assessing volatility.
On most occasions, traders believe that volatility is the same as bearishness or bullishness. This is wrong.
Volatility does not tell about the strength or direction of the trend. It, however, tells how much the price fluctuates.
The ATR only looks into how far the price fluctuates and not really how much the price moves in a given direction.
Let us look at the difference between volatility and momentum.
Momentum, on the other hand, is more of the opposite of volatility.
It tells the strength of the trend in a specific direction.
When the market is in a high momentum, you will only see one color of candles, really few candles moving against the trend, as well as small candle wicks, if any.
This refers to how much price fluctuates around the average price.
When the market experiences high volatility, price candles normally have long wicks; look at a combination of bearish and bullish candles, their candle body is also relatively smaller than the wicks.
This is the period when tight stop losses are likely to be triggered by the inherent wicks.
Using the Average True Range Indicator in Technical Analysis
So as to ensure that you are making the right trading decisions, it is crucial for you to know the way your preferred indicator is built.
This is where I am going to outline the way the ATR indicator is calculated simply without the need to get into complicated mathematical calculations.
The average true range is used in measuring how much on average the market’s price moves.
This is normally calculated using one of three methods of defining the True Range (TR) values, as per the way the candles are formed.
Current high less the current low.
This is used when the current candle’s range is larger than the previous candle.
Current high less the previous close or absolute value.
This method is used when the current candle tends to close higher than the previous candle.
Current low less the previous close or absolute value.
This is used when the current candle closes lower than the previous candle.
It is okay to, therefore, assume that when the range of the candles is larger, then the value of the Average True Range is greater.
Normally, the Average True Range (ATR) is based on 14 periods that can be calculated on a monthly, weekly, daily, or intraday basis.
The first true range value is obtained by subtracting the low from the high, to form the beginning.
The 14-day Average True Range forms the average of the daily true range values for the last 14 days.
The ATR indicator formula is as shown below:
Why is the Average True Range Strategy Useful for Traders?
In simple terms, when a stock or a currency pair is experiencing a high level of volatility, it has a higher ATR, while a stock or a currency pair with a lower volatility has a lower ATR.
The ATR indicator can be used by traders to enter and exit trades and to also put a stop loss and take profit orders.
For me, I use the average true range for identifying the stop loss and take profit target levels. This way, the probability of being stopped out, and then the market continues in your predicted direction is low since the indicator accounts for the volatility of the market as of that time.
The ATR indicator stop is even more helpful when you can’t identify a recent high or low to help gauge your stop loss level.
As a result, the Average True Range trading strategy can be very helpful in making trading decisions.
The ATR indicator is majorly used as a tool for setting stop-loss levels.
Traders are prepared for greater volatility and wider price fluctuations whenever the ATR is high.
As a trader, you can therefore, set your stop-loss orders further away to avoid being prematurely stopped out of the trade.
On the other hand, when the ATR has lower volatility, you can use a tighter stop loss, and this helps improve your risk to reward ratio without jeopardizing your trade.
The Average True Range Indicator also enables traders to understand the profit potential of trades.
It is possible to set a closer take profit in a low volatility market, and placing it further away if the volatility is very high.
You can be good at analyzing the areas of interest in the chart, but you can’t tell with certainty where the market is likely to react even when you are assessing the momentum of the trade.
The ATR Indicator as your Universal Market Tool
The ATR is a very important tool for changing and adapting to changing market conditions.
It can also be used to anticipate market turns when a substantial change in volatility is observed.
Many traders get inconsistent results normally due to an inflexible trading approach.
As a trader, you can overcome these problems using the volatility stop, as well as the adjusted take profit placement.
I have heard a lot of times newbie traders talk of how they got stopped out, and then the market moved in their anticipated direction.
Read: Trading Mistakes Made by Beginner Forex Traders
The ATR indicator can really help you to avoid such instances.
Additionally, with the volatility behavior of the higher time-frames and the variances between uptrends and downtrends, the ATR makes for a universal trading tool.
ATR Indicator Limitations
The average true range indicator has two main limitations.
The first is that it is a subjective measure, to mean that it can be interpreted by different traders in different ways.
No ATR value tells you with certainty that a trend is about to reverse or not.
Its readings should instead always be compared to earlier readings to understand a trend’s weakness or strength.
The other limitation is that ATR also only measures volatility and does not measure the direction of an asset’s price.
This at times leads to mixed signals, mainly when markets are having pivots or when trends are at turning points.
In an example, a sudden increase in the average true range after a large move counter to the prevailing trend could result to some traders thinking that the ATR is confirming the old trend, when this may not really be true.
Always remember that this is not a trend following indicator, but a volatility indicator.
I have only included this as a weakness since most people view it this way.
However, for me, this is what makes it great since it does a good job of what it was meant to do.
When using the ATR indicator, you should have your way (based on your trading strategy) of identifying the trend then use the average true range indicator for setting the stop loss and take profit targets.