The ATR (Average True Range) is a technical analysis forex indicator that decomposes the entire price range for a certain period to measure market volatility. Specifically, it was introduced by market technician J. Welles Wilder Jr. as a measure of volatility.
The true range forex indicator is considered as the greatest among current high minus the current low, the absolute value of the current low minus the previous close, and the absolute value of the current high minus the previous close. So, the ATR indicator is a moving average, usually using 14 days of the true ranges.
How To Calculate ATR?
While trading, you can use shorter periods than 14 days for generating more trading signals because longer periods tend to generate fewer trading signals. For instance, if a short-term trader wishes to analyze only the volatility of an asset for five trading days, he/she can calculate the 5-day forex ATR.
You may assume that the historical price data is set in reverse chronological order while calculating. When the calculations of the true range are done over the 5 most recent trading days, they are averaged for calculating the first value of the 5-day ATR.
How to Use The ATR In Trading?
Originally, Wilder proposed an ATR trading strategy. This strategy was a major part of his trend-following volatility system. The rules are set on the assumption that the trader has followed the trend when entering a trade. For example, you may make new highs every day by purchasing into a market. It is reasonably simple to follow top forex expert advisors rules trading system. It dictates effectively where you need to stop and reverse your position. You need to follow these steps –
- First, multiply the ATR with a constant. Wilder recommended 3.0 as the constant. The resulting value was called ARC by him.
- Then, find the SIC (Significant Close). It is the extremely favorable close in the next ‘N’ days.
- Finally, square and reverse the position one ARC from the SIC.
The strategy was developed to use daily values. As for the rules, ‘N’ was set at 7 for giving a sufficiently quick reaction to volatility. In a broader sense, you may use the ATR as a guide to appetite in the market to pursue price movements. For instance, when a market moves higher, it only happens for a strong appetite that stays for further buying that the range will keep on extending. If ranges narrow, some can interpret it as suggestive of declining interest in terms to pursue the total directional movement.
Since the ATR gauges market volatility, you can also use it as a tool to guide stop and limit placement, and position sizing. Probably these uses are more prevalent nowadays than as a trading signal generator.
The ‘Turtles’ is a famous group of novice traders that achieve great success in trading in the eighties after only a few weeks of training. This group used the ATR for position sizing to normalize the Dollar volatility in the positions. Their trading rules had them trade on any one of over twenty different contracts, according to price movement.
In their case, they were unaware of the winning and losing positions. So, they had to adjust for the volatility of several markets. The contract moved more than the others which prevented a huge loss. The ‘Turtles’ used the 20-day ATR specifically. The higher the value was, the smaller position the group took, and vice versa.
Originally, the ATR forex indicator was designed for commodities, but these days it is widely applied to forex and stocks. For example, the ‘Turtles’ mentioned earlier traded a cross-section of commodity, forex futures, and bond and used the ATR for all as the position-sizing tool. Since volatility is a global market concept, ATR forex sizing works just as well as ATR commodity sizing.
As the ATR considers the magnitude of range simple and does not measure direction, it limits utility as a means to generate trading signals. However, the tool is useful in providing an idea about the movements of a market. In turn, it informs important trading decisions like position size and stop placement. To find out how to use ATR, experiment with it in a risk-free demo trading account before applying the ATR trading strategy on a live account.