What is an ATR indicator?
Before you use any tool, it is important to understand what it is and what it is for. Let's start with what is the ATR.
ATR is an abbreviation for the Average True Range of the price fluctuations of the selected instrument for a certain period.
It becomes clear that this indicator is a tool for determining volatility. This is its main purpose, misunderstanding leads to errors in use, which will be discussed below.
Why would a trader want to know the ATR?
Why should a trader know the Average Moving Range (ATR)? It is well known that financial instruments periodically change direction during their movement.
To make profitable trades, it is important for a trader to understand in what direction and for how long the price movement will continue and after what time there will be a reversal. Often it is difficult to determine with the help of technical analysis or trend indicators if the price keeps on growing or reverses.
If you find yourself in a situation where, after making a correct technical entry, the price is reversed against you, the ATR indicator will be an additional tool for you to find the right decisions at such crossroads. And if it does not answer the question about the direction, we can find out about the margin to move in a certain direction.
How to determine ATR and how to calculate it?
Before proceeding to the practical application of this tool, let us consider the methodology of its calculation. You can determine the average true range of the price fluctuations visually (manually) and automatically, using the trading indicator provided for this purpose. Both methods are effective. As a rule, a period of 14 candles is taken for this.
To visually (manually) determine the ATR, you need to select the 14 candles in a row on the time frame that you use for trading, minus the paranormal, ie too big, contrasting against the background (usually formed on the news).
Then, out of the selected candlesticks, determine the average size by eye and find its parameters - the maximum and minimum. To get the ATR value, subtract the minimum value from the maximum value of the candle. For example, 1.2083 - 1.1980 = 0.0103, i.e. 103 points.
To automate this process, a specially designed indicator ATR is available in most trading platforms. If you are using the trading terminal MetaTrader 4, you can find it in the indicators menu, in the folder with oscillators. After dragging it with the left mouse button on a chart, you will see the ATR oscillation curve appear in a new window. The default setting has a period of 14, you do not need to change it.
It is worth noting right away that in order to be used in trading we only need to know the ATR value at the moment. This is displayed in pips and is shown by moving the mouse over the end of the chart line and near the indicator name in the upper left corner of the window. For example, a value of 0.0096 means 96 points.
How does the ATR indicator calculate the average true range? The true range is taken as the basis. It is calculated using three indicators:
- The maximum value of the candle minus the minimum value of the candle;
- The previous candle's close price minus the current candle's maximum;
- the previous candle's close price minus the current candle's minimum.
The program selects the highest value out of the three and calculates it as the true range. The average value of this indicator for the last 14 candles of the selected timeframe is the number of ATR.
How to use the ATR indicator in trading?
Based on the nature of the ATR described above, the knowledge of the average true range value allows the trader to understand whether there is still a margin of safety of the instrument being traded or whether a reversal is imminent.
However, it should be noted right away that using the ATR as a standalone tool is not useful. It should be used in combination with other methods of market analysis and price direction prediction.
Here are a few parameters you should use this indicator to determine:
1. use the ATR indicator as a percentage in order to determine how much more price can pass in the direction of its current movement. Thus, knowing the value of the daily ATR and calculating what percentage of the range the instrument has already passed for the day, you can understand - will the movement continue in this direction or price will turn around. So, after passing 70% of the daily ATR it is highly probable that the price changes its direction.
2. When trading intraday, it is recommended to consider the ATR value when setting a stop loss: its size should be at least 20% of the ATR. For example, if the price of the selected instrument fluctuates within the range of 80 points during a day, then the stop-loss should be no less than 16 points.
3. Use the value of the ATR as a guide when setting Take Profit. To do so, take the ATR indicator in pips and subtract from it the number of pips that the price has already passed. Obtain the potential for a move to the end of the period. Take Profit, set a little less than the obtained value.
Let us consider the application of these rules using an example. If you have experience in trading, you may be familiar with the following situation. The price of the selected instrument has been consolidating for some time in a sideways corridor under a strong technical level.
According to the rules of technical analysis, when the price breaks through that level from bottom to top and remains above it, it should continue growing, and therefore it is worth opening a buy deal.
Therefore the trader has a choice: either to enter and risk a stop loss in case this breakout proves to be false, or not to enter and then see the price continue its rapid rise after the consolidation.
This is where the ATR indicator comes in, as it will help you determine the most likely scenario and make a decision.
However, there is a catch: when the price breaks a level, it can either be a true breakout, followed by a rise, or a false breakout, which can result in the price returning below the breakout horizon after the breakout and a few candles above it.
Let us analyze the same situation using the ATR indicator. We see that the average true swing range for the day is 0.0089, i.e. 89 pips. We look at the chart and determine how many pips the price has gone from the beginning of the day to the breakout.
If this value is less than 50% of the ATR (in our case it is less than 44 pips), there is a growth potential and a deal can be opened. And the larger the gap left to the ATR, the larger the potential profit. Depending on the distance covered since the beginning of the day, there are three possible solutions.
1. For example, in the above described technical picture the instrument's price has passed 15 points during the day. It means that there is a great possibility that it can rise by 74 points on the average. First, the trader understands that such a deal can be opened, and second, he or she knows the size of the potential Take Profit - it would be better to expose it to a bit less than the 74 points specified above.
2. the trader sees that most of the ATR for the day is passed at the moment of breaking through the level, at this point, there is a high probability that it is a false-break and the price will reverse. It means that it is better not to buy, because there is no margin for growth. But in this case it would not be a good idea to open a sell, it would be better to wait for the next day and base your actions on the volatility and the technical picture.
3. Since the beginning of the day passed on average half of ATR. If you open a trade, the probability of its processing to the profit will be 50 to 50. In this case stop loss and take profit values are approximately equal. And here each trader makes a decision based on his or her trading system. If it allows conducting deals with risk-to-profit ratio of 1:1, such position is acceptable.
In addition, it is worth taking into account additional signals provided by other technical indicators to confirm the correctness of the decision. Otherwise, it is better to skip such an entry point.
Errors in the use of ATR
As noted at the beginning of this article, the ATR indicator shows the volatility change. It does not show the direction of price movements, overbought and oversold zones, it does not give entry points into the trade.
Therefore, it is important not to make the following mistakes when using the Average True Range indicator:
1. Do not try to determine the price direction with the ATR. If the indicator line goes upwards, it does not mean that the instrument price will grow. It means that the range of price fluctuations is widening. And vice versa. Use other tools to determine the direction.
2. Do not use the ATR to determine whether an instrument is overbought or oversold. It is not designed for it and neither are the corresponding levels, like Stochastic.
3. it is not appropriate to look for divergence between the ATR chart and the price chart. First of all, it is wrong due to the nature of the indicator, and secondly, MACD and Stochastic do it much better.
4. Do not compare the ATR values for different instruments or for different timeframes of the same instrument. It is absolutely uninformative. All that should be of interest to you for practical application is the ATR value at the moment.
Thus, trading by ATR allows a trader to increase the percentage of profitable trades by understanding the volatility margin.