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Enter the thrilling world of trading, where opportunities for gain and loss lay around every corner. Mastering volatility is crucial for success in this fast-paced environment. This is where the average true range shines. Traders can depend on it to measure market volatility and make informed decisions.
This article will examine the ATR indicator and its complexities, illuminating its significance in the ever-changing and frequently unpredictable trading environment.
What is the average true range (ATR) indicator?
A technical analysis tool that sheds light on market volatility is the Average True Range indicator, full form of ATR. It was created and first published by J. Welles Wilder Jr. in his 1978 book “New Concepts in Technical Trading Systems.”
In the ATR indicator, the construct of “True Range” bears paramount importance. Among these three numbers, ATR is the highest:
- Amount of difference between the current high and low
- The exact amount of difference between the last close and the current high
- The exact amount of change between the last close and the current low
The ATR calculation is determined by averaging these values over a specific period, typically 14 days.
The ATR formula is as follows:
If there is a previous ATR: Previous ATR (n-1) + TRn
Where n is the number of periods and TR is the true range
If there is no previous ATR: (1n)inTRi
Where TRi is a particular true range (for example first day’s true range and then so on)
This is an illustration of what the ATR indicator looks like.
How to use the ATR indicator?
When traders are looking for good entry and exit points, they often use the ATR. Large price swings and more profit opportunities are usually signs of high volatility, which is indicated by a high ATR value. If a trader anticipates future increases in volatility and the asset’s price remains stable with a low ATR, it may be a good opportunity to enter the market.
Orders for stop-loss positions are frequently entered using the ATR as well. One common practice among traders is to place stop-loss orders at a distance from their entry point that is multiple of the ATR value. It keeps losses to a minimum while letting air into the trading room.
Lastly, the ATR can be useful for spotting trends. A falling ATR might mean that the present trend is losing steam, while a rising ATR could mean that a new trend is about to begin.
Advantages and limitations of ATR trading
Advantages:
Volatility measurement: One of the best ways to gauge market volatility is with the ATR. For risk management purposes, knowing the extent to which prices fluctuate is essential, and it can assist traders in doing just that.
Identifying market entry and exit points: The ATR is often used by traders to find good times to enter and exit the market. Potentially profitable market entry points include high ATR levels, whereas potential exit points include low ATR levels.
Setting stop-loss orders: One way to use the ATR indicator strategy is to set stop-loss orders. Limiting possible losses, traders can set stop-loss orders at a specific multiple of the ATR value.
Limitations
Does not indicate direction: Although the ATR is a measure of volatility, it does not reveal which way prices will go. To ascertain the trend’s direction, traders must rely on alternative indicators or methodologies.
Lagging indicator: Like many other technical indicators, the ATR is a lagging indicator. Since it relies on historical data, its ability to foretell how prices will change in the future is questionable.
Dependent on the look-back period: Specifying a different look-back period when calculating the ATR will yield different results. The ATR values for the same data can be influenced by the look-back periods, leading to different interpretations.
Examples of ATR indicator in action
Suppose a trader is observing a stock currently priced at ₹100. And let’s assume the ATR for the stock, calculated over 14 periods, is 2. It means that on average, the stock has moved ₹2 per day.
The trader decides to buy the stock and take a long position. To manage risk, let’s assume, they decide to set a stop-loss order at an ATR multiple of 2 below their entry point. It means the stop-loss order is set at ₹100 – (2 ₹2) = ₹96.
The price of the stock oscillates the next few days. The stop-loss order will be activated if the price falls to ₹96. The position will then be sold to avoid further losses. On the other hand, if the price rises, the trader can adjust the stop-loss order upwards to lock in profits while still protecting against a potential downturn.
To get the best results, remember that even though the ATR is a strong tool, it should be used with other tools and strategies.
Bottomline
The average true range (ATR) indicator is a powerful trading tool. It aids traders in determining the best times to enter and exit the market, as well as how to set stop-loss orders, by providing functional information about market volatility.
Nevertheless, it should be utilised alongside other indicators and strategies due to its limitations, just as with any tool. A trader’s ability to adapt to the dynamic trading environment is correlated to how well they master the ATR and apply it appropriately.
FAQs
The best ATR value can vary depending on the trading strategy and the market being traded. Some traders might use a smaller ATR multiple for short-term trends, while others might use a larger ATR multiple for longer-term trends. However, it’s been suggested that an ATR period of 10 is optimal for measuring volatility. Remember, the ATR is just one tool and should be used in conjunction with other indicators and strategies.
The Average True Range (ATR) is typically calculated over a default period of 14 sessions, whether those are minutes, hours, days, or weeks. This period can be adjusted according to the trader’s preference. Shorter periods might generate more trading signals, while longer periods could produce fewer signals but with a higher probability. However, it’s important to remember that the ATR is a measure of volatility, not price direction.
The Average True Range (ATR) indicator can be used to set stop-loss orders in trading. A common method is to set the stop-loss at a multiple of the ATR value from the entry point. For instance, if the ATR is 2, a trader might set the stop-loss order at 2x or 3x the ATR value away from their entry point. This approach adjusts the stop-loss level according to the market’s volatility, providing a dynamic and adaptable risk management strategy.
The Average True Range (ATR) and the Average Daily Range (ADR) are both measures of market volatility, but they calculate it differently. The ATR includes price gaps as it calculates from the previous day’s close, making it sensitive to overnight price jumps. On the other hand, the ADR is simply the average of intraday high-low values, excluding price gaps. Therefore, the choice between ATR and ADR depends on whether the trader wants to account for price gaps.
Yes, the Average True Range (ATR) indicator is considered an oscillator. This means that the ATR oscillates or varies over time, reflecting changes in market volatility. However, unlike other oscillators such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD), the ATR does not indicate the direction of price movement. Instead, it provides a measure of market volatility, which can assist in stop-loss placement or determining trade size. It’s a valuable tool for assessing market behaviour.