Average True Range (ATR) Indicator Explained

Definition of the ATR Indicator

For the first time in this series, we deal with an indicator that has nothing to do with the direction of the asset. This is the Average True Range (ATR), an indicator which was initially created for the commodity markets by J Welles Wilder. The commodity markets show very intense volatility which goes beyond that of the forex market, with gaps occurring very frequently. J Welles Wilder therefore created an indicator to measure the volatility of the asset, taking into cognisance the gap areas. The indicator has since found application in the forex market.

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The Average True Range works in rising and falling markets. Traders should note this very well. That the line in the indicator window seems to be rising when the market is falling should not cause concern on the trader’s part; it only means that the market’s fall is being triggered by high volatility on the part of sellers. The ATR can therefore reach high values after a marked fall in prices as a result of panic selling.

In the same vein, the ATR can attain low values even at the top of an uptrend. This is because having trended for a long time, markets will start to cool off and get into long periods of sideways movement or consolidation as traders await new direction for their trades.

The Average True Range works the same way as other volatility indicators. The rules of forecasting of price changes based on the ATR are as follows: the higher the ATR’s value, the higher the probability that the trend will change. The lower the ATRs value, the weaker the trend movement is going to be.

Components of the Average True Range

The average true range is made up of a single line which is plotted based on 14 periods. The ATR calculation can be done daily, weekly or monthly. An intraday calculation can also be done. There must be a starting value (High minus Low) and the first 14-day ATR is the mean of the period TR values for the last 14 days. The previous period’s ATR value is added to smooth out the value.

Usage of Indicator

The Average True Range is a volatility indicator which indicates the degree of buyer or seller interest in a move. Large true ranges are seen when there is a lot of market interest on both sides.

Indicator Settings

The indicator is listed on the MT4 in its own category of indicators. To attach it to the MT4 chart, click on Insert -> Indicators -> Oscillator -> Average True Range

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The lines of the Average True Range indicator can be enhanced by either increasing the line thickness or by changing the colour of the indicator to make it more visible.

Usage of the Average True Range in Forex Trading

The Average True Range is not used to generate trading signals. Rather it finds use in validation of the strength of market moves. Remember that the ATR is a measure of volatility. So this is what the ATR can do for a trader.

  1. Large ATR values confirm that the move being traded will generate a lot of pips in terms of price movement. Small ATR values means there is little volatility and therefore there will be little movement in terms of range.
  2. The ATR can also be used for volatility profiling of currency pairs so that traders know exactly how much volatility to expect when trading a particular currency.

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This chart shows the value of the ATR when compared with three areas of chart with increasingly narrower price ranges. But notice that the maximum ATR value in this GBPUSD chart (0.0031) is much less than the maximum ATR for the GBPJPY chart on the same day (0.3746). This shows the trader at a glance that there is 125 times more volatility on the GBPJPY than there is on the GBPUSD.

  1. The ATR is also used in some instances to set the stop loss for a trade. For a long trade, subtract a multiple of the Average True Range from the trade entry price (e.g. 2 X ATR is subtracted from trade entry price). For a short trade, add a multiple of the ATR to entry price (e.g. 2 X ATR + entry price).

Remember how we compared the ATR values of the GBPUSD and GBPJPY? It is in setting a stop loss and take profit that this information becomes relevant. Just by looking at the comparison, it is clear that traders cannot use the same stop loss and profit targets for both currency pairs because one is much more volatile than the other. This also raises the question of risk management and the ability of the trader’s account to handle the volatility levels of currency pairs such as the GBPJPY.

Before jumping into any trades, using the ATR indicator will show how many pips the currency pair to be traded has been moving on a daily basis for a period of time (volatility profiling). This information can then be used to set the stop loss and profit targets for the trade, and subsequently can be used in calculating the degree of risk that a trader’s account can take without deleterious effects.

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