Average True Range Simple Explanation and Strategy

by FX EA Review
Average True Range Simple Explanation and Strategy

Measure the volatility with ATR

Average True Range or ATR is one of the earliest and essential tools of technical analysis available. In general, ATR measures the average volatility of an instrument during a specified period. How do we calculate ATR? Let’s look at the formula below.

First, we need to find a True Range (TR):

Here is the formula:

formula

In other words, to find the TR, we will use the highest value (regardless of whether it’s positive or negative) of the following:

  1. The difference between the current high and the previous close
  2. The difference of current low and the previous close
  3. The difference between the current high and the current low 

Second, we will find the average of TR values for a specified number of periods (candles). If we use the most common number of periods (14), the formula of ATR will look like this:

ATR = ((Prior ATR x 13) + Current TR) / 14

Let’s look at the daily chart of AUDNZD below. As we can see, the more significant daily price changes are followed by the growth of ATR value (see the circled area in the indicator’s window). When the price calms down, the values of ATR (the rectangular area) go down too. 

ATR chart

How it all started: overcoming lock limits with ATR

J. Welles Wilder Jr. (born in 1930) developed ATR along with other core indicators included in the modern charting software. As Wilder traded futures, originally, the indicator was intended to measure the volatility of commodity markets. 

Wilder traded trading systems that were based on volatility. The basic idea of the systems was that the high volatility follows the low volatility. So, for Wilder, it was imperative to know the adequate actual volatility. Futures markets have a concept known as a lock limit. Lock limit happens when the commodity prices reach a predefined daily change. Then further trading gets suspended on that day. In the 1970s, because of the high inflation environment, many commodities such as grain, pork bellies etc. often would reach lock limits. Sometimes the market opening price would already reach the up limit, and no further trading occurred. It wasn’t adequate to use the range of prices of limit up day to measure the volatility. Instead of the daily simple trading range (high minus low), the real volatility was hidden in the opening gap that occurred quite often back then. Let’s look at the example of the daily chart of Wheat futures in 1972 below.

ATR chart

If the market opened higher with a gap, “the difference of current high and the previous close” (discussed earlier) would calculate the adequate volatility on that day.

How far will it go? Find where to exit with ATR

Imagine you’re an intraday trader. You decided to open a position and hopefully cover it in profit by the time the market closes. It’s not a big deal to open a position. What really makes money in trading is how you exit the market. How do you define your exit point? ATR can help you with that. As the indicator measures the average volatility for a specified period, we can use this information to get an approximate move potential that the instrument might have. 

Below we can see a chart of USDJPY. We opened a long position (green arrow). The market has been moving from 107.37 to 107.04, so the range today is 107.37-107.04=0.33.

ATR chart

On that day, ATR is 0.94, which gives us the statistical ground to assume how far the price might move up. To find the upside move potential, we need to subtract the current range from the value of ATR: 0.94 – (107.37-107.04) = 0.61 and add it to the last high of the day (107.37). The black line represents the price target based on the ATR on that day.

ATR chart

Notice that the price hasn’t exactly reached 107.98 but started to reverse at around 90% of ATR. 10% deviations are normal, as the ATR represents only an approximate statistical value.

Even robot will get it

Daily ATR is quite an objective metric to measure the move potential on a given day. The only way it can be different from one trader to another is when a different period of calculation is applied. It would be reasonable to integrate the indicator in automated trading systems. 

For example, we can set a rule such as: “If Day High – Day Low < 0.5 ATR (14) and market price > SMA (20), then “buy”. 

This rule will generate an entry signal when the current market price is above the Simple Moving Average of a 20 period ONLY IF there is still more than 50% intraday move potential available based on ATR. Here we have two elements:

1)An example of an entry signal – the price is above SMA (20)

2)A filter condition – enter only if there is a defined move potential ((Day High – Day Low) <0.5 ATR (14)).

Follow the volatility: ATR common strategies 

We can use ATR to identify the splash in volatility and follow the subsequent move towards which, the splash occurred. ATR doesn’t tell us which direction to take but what it shows is how powerful the market move is in either direction relative to the past market performance. 

Let’s look at AUDUSD char below. To find a sell signal price, we need to subtract the ATR value (0.0039) from the closing price (0.6823). The sell signal price would be at 0.68230-0.00396=0.67834. We’d have a sell entry signal if on the next day the market is traded below 0.67834. 

ATR chart

The signal would work vice-versa for long signals as well. The logic here is to follow the direction of volatility.

Day trading with ATR

For day traders, ATR offers a trading edge too. We can use the ATR as a confirmation for the reversal setups. Let’s say the instrument reached the ATR potential somewhere around 113.33(see the chart below).

Day trading with ATR

Suppose there are no other reasons to continue the move, such as news, abnormal volume etc. We should question whether the move occurred represents changes in the market objectively or it’s just sort of a random splash. As there is still plenty of time until the end of the session, we can expect a decent move in the opposite direction at least as a 50% correction. Ideally, we would have some support(resistance) area nearby and a price action pattern as an entry signal (look at the local support around 113.3 in the example above).

The same principle applies for both directions – bullish and bearish.

Remember, ATR is just a statistical value. Traders must keep in mind that ATR works best only in the “normal” market conditions. Other words – no special data releases, unexpected news, abnormal volume etc. Think of WTI heading into the abyss in the middle of April. Who would think about any technical indicators at the moment?

Conclusion

The ATR indicator was created as the result of an inability to measure the volatility in futures markets due to lock limits. Today ATR is a great tool to quantify the volatility of the forex market. We can use the indicator for measuring the move potential of a pair during one trading session. We can also get entry signals with ATR. Automated systems can also benefit from using ATR. Integrated into the algorithm, the indicator with its simplicity and the objectivity can help to sort out only entries with a reasonable reward. Keep in mind that ATR is a statistical value and works best in the markets where nothing extreme is happening at the moment. 

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