ATR Indicator: Strategy and how to use it [Guide]
J. Welles Wilder is one of the most innovative minds in the field of technical analysis. In 1978, he introduced the indicators known as True Range and Average True Range (ATR Indicator) to the world, as measures of volatility.
We know that these indicators are used less frequently than many others, which are perhaps more immediate, but their function in supporting a trader in and out of trades is extremely useful and can lead to an increase in profitability.
Let’s see the key points of the ATR:
- The Average True Range (ATR) is a market volatility indicator used in technical analysis
- It is typically derived from the 14-period simple moving average
- The ATR was originally developed for use in commodity markets, but has since been applied to all assets
In this guide we will dig deep into the ATR Indicator and guide you in its use in trading. To practice with this indicator it is advisable to have a trading platform available.
ATR Indicator: What is the Average True Range?
The Average True Range (ATR Indicator) can be a powerful technical analysis tool and was first described by J. Wells Wilder in the book “New Concepts of Trading”.
This tool measures market volatility by averaging this volatility over a stock’s price range over a specified period of time. The ATR Indicator shows how much a certain asset moves and is essential in trading, especially for evaluating where to place a Stop Loss.
While we are used to looking for trading indicators that tell us when to enter or exit a trade, it is also very important to understand the swings we can expect from the price.
Volatility is not a secondary indication, far from it, but it is often underestimated, especially by novice traders.
ATR in Trading
The ATR indicator moves up and down when the price of an asset rises or falls. The ATR reading varies over time, adapting to the observation period and price fluctuations.
On a one-minute chart, a new ATR reading is calculated every minute. On a daily chart, a new ATR is calculated every day. All of these readings are plotted to form a solid line, so that traders can see how volatility varies over time.
To calculate the ATR indicator manually, it is first necessary to calculate a series of real intervals (TR). The True Range for a given trading period is the greater of the following:
- Current high minus previous close
- Current minimum minus previous close
- Maximum current minus minimum current
It doesn’t matter if the number is positive or negative, the highest absolute value is used in the calculation. Values are recorded for each period, then averaged over generally 14 periods.
J. Welles Wilder, Jr., who developed the ATR, used this formula for subsequent periods, after completing the initial 14-period ATR, to make the data more homogeneous:
Current ATR = ((Previous ATR x 13) + Current TR) / 14
ATR Indicator Formula
The first step in calculating the 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.
The Average True Range, on the other hand, is wider and is defined as:
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How to use ATR Indicator (Average True Range)
To understand how to use the ATR, let’s take a very simple example:
Using the ATR to evaluate the movement of prices is the best use for this indicator which is different from all other oscillators such as the Money Flow Index, the Stochastic or the CCI.
Let’s take a look at the 5-minute Apple chart combining ATR and price:
In Apple’s intraday chart, both the ATR and the share price are in some sort of channel. The ATR is in a horizontal channel with low volatility, while Apple is pursuing a clearly defined uptrend.
This combination of low volatility combined with a clear uptrend makes the trader realize that upward movement is measured, is stable and can be traded with some confidence.
At a certain point the volatility undergoes a very rapid increase signaling a probable trend reversal.
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ATR Indicator Setting
Generally, the ATR is set to 14 periods, which can be intraday, daily, weekly or monthly.
- To measure recent volatility, a shorter average is used, for example 2 to 10 periods.
- For long-term volatility, the indicator is set between 20 and 50 periods.
Traders can use shorter periods of 14 days to generate more trading signals, while longer periods are more likely to generate fewer trading signals and still be more reliable.
The strategies for ATR indicator are numerous and to learn them you need to study and improve your knowledge of technical analysis.
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Short term ATR strategy
Now let’s see how day traders use the ATR for intraday trading operations. Let’s take a practical example so as to better understand how to use the indicator.
Let’s say a stock moves $ 1 per day, on average. There is no significant news, but the stock is already up $ 1.20 on the day.
The trading range (maximum minus minimum) is $ 1.35. The price has already moved 35% more than the ATR average and this means that aiming higher could be an imprudent choice.
Given that the price has already significantly increased and moved beyond the ATR average, it is more likely to drop and remain within the previously established price range.
Selling short can be a good option, but you have to wait for a valid signal and it must come from another indicator, not just the ATR.
- Market entries and exits should not be based solely on ATR. The ATR is a tool that should be used together with a more complex strategy to filter operations.
- To get input signals you need to use other indicators such as moving averages and crossovers.
ATR stop loss
Given that a complete trading strategy is required to trade on the markets in a profitable way, it is also true that Stop Loss must be part of every strategy.
Trading without stop loss is like driving at night with the headlights off, the risks increase enormously, the ATR Indicator (Average True Range) is very useful in positioning the Stop loss.
Depending on the objectives of the strategy and risk appetite, the Stop Loss can be set with an ATR multiplier, which can be 2%, 10% or 20% of the Average True Range.
Of course, we must also consider the slippage, or the sliding of prices that can “jump” the Stop Loss that fails to intervene at the entered price.
So there is always the possibility of losing more than the money we anticipated when the stop works, keep this in mind.
Be that as it may, the goal is to limit losses and avoid suffering the dramatic drawdowns that are part of trading.
Remember that there is no perfect strategy, there are no foolproof trading signals and, as famous traders teach, much of the profit depends on how the trades are managed, minimizing losses and letting profits run as much as possible.
How does ATR work?
The Average True Range (ATR) is an exponential moving average of the True Range.
Wilder used a 14-day ATR to explain the concept but, as we have seen, traders can use shorter or longer time frames based on their preferences and needs.
Longer times will be more reliable and will likely lead to fewer trading signals, while shorter times will increase trading activity but will provide many false signals.
Below we see the True Range and the Average True Range on the same graph:
It is clear that the peaks in the TR are followed by periods of time with lower values for the True Range.
The ATR, on the other hand, draws a line by making a constant average between these data and makes them easier to interpret in a trading strategy.
In principle, the peaks marked by the Average True Range must be like “alarm bells”.
When the price is close to the limit levels shown by the ATR, it will probably rebound remaining within the range of prices shown previously.
This is not an absolute rule but it is very useful in a trend, because it signals the continuation of the same or the probable inversion, when prices go well beyond the ATR visible on the chart.
Although at this point it should be clear, the Average True Range does not directly provide entry or exit signals but outlines a channel within which prices move, in this we can find a similarity with the Bollinger Bands.
The Average True Range (ATR Indicator) is a versatile tool that helps traders measure volatility and can provide, when used with other indicators, also signals of entry and exit from a trade.
An effective trading strategy cannot help but take into consideration the volatility of prices and the ATR is a valid indicator for this measurement.
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As with all indicators, learning how to use the Average True Range also requires a lot of practice, possibly without risking money.
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The default setting is on 14 periods but you can go down to get more signals or go up to get less but with greater reliability.
Yes, it is an indicator that helps in positioning an effective Stop Loss.
They are strategies that take into account the volatility to enter or exit a trade but the ATR alone does not provide signals.
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