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Trading with the average true range indicator

The average true range (ATR) indicator is a technical indicator that was first described in 1978 by famous technical analyst J. Welles Wilder Jr. Here, we explain how the ATR works and how to use it in your trading.
Traders
Source: Bloomberg

What is the average true range indicator?

The average true range (ATR) indicator is one of a number of popular trading indicators, and it is used to track volatility in a given time period. It moves up or down according to whether an asset’s price movements are becoming more or less dramatic – with a higher ATR value representing greater volatility in the underlying market, and a lower ATR representing the opposite.

You can use the ATR to establish where to place a stop or limit order, as well as when you might want to open or close a trade. This is because, by tracking volatility in a given time frame, ATR shows when price movements might become more or less sporadic as volatility increases or decreases.

How does the ATR work?

The ATR works by creating an average of the true range, which is the classic measurement of the range of movement in an asset’s price. The average true range, in contrast, is a smoothed moving average of the true range values, which seeks to make assessing an asset’s volatility easier and more accessible for traders.

ATR was originally developed for the commodities market, but it can also be applied to forex, stocks and indices. It relies exclusively on historical price action data, but it does not itself show price movements.

How to calculate the average true range

To calculate the average true range, you would first need to calculate the true range. You would do this by taking the largest of these three calculations:

  • The current high minus the previous close
  • The current low minus the previous close
  • The current high minus the current low

You would repeat this throughout a specific time frame to achieve a moving average of a series of true ranges. A 14-period moving average is recommended as a basis from which to work out the average true range, usually over a 10- to 14-day period. For shorter time frames—hours for example—it’s recommended to use between two to 10 periods; for longer time frames—weeks or months—20 to 50 periods are recommended. From the ATR calculation, a trader can tell whether an asset is experiencing greater or lower volatility in a particular trading session.

How to use the average true range indicator in your trading

In a particularly volatile market, you might want to implement a trailing stop at a certain amount of points behind the current market price. This will help to lock in profit while also protecting against negative movements if an asset’s price is unpredictable.

The ATR indicator can help you do this by showing when volatility is rising or falling. If this is the case, you might want to reduce or increase the level at which you have placed a trailing stop to secure your profit while also protecting against potential heavy losses.

While the ATR is a useful tool for assessing volatility levels, it should be used alongside other technical indicators to confirm your decisions about whether to open or close a position. Other indicators that can help assess volatility levels include Bollinger bands and Keltner channels.

Several online trading platforms have a function to overlay the ATR onto trading charts. These include the tastyfx online trading platform and MetaTrader 4 (MT4)—a popular platform for algorithmic trading. This makes it easy to track volatility in an underlying market without having to calculate the average true range manually.

Summing up the ATR

  • ATR is a smoothed moving average of volatility over a given time frame
  • It can be used on the forex, index, stock and commodity markets
  • A 14-day moving average is the recommended basis for the average true range, but other periods can be used for shorter or longer timeframes
  • ATR is often used for assessing when and where to enter or exit a position
  • However, while ATR is useful in these respects, you should use it in conjunction with other indicators to confirm forecasts

This information has been prepared by tastyfx, a trading name of tastyfx LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information. tastyfx accepts no responsibility for any use that may be made of these comments and for any consequences that result. See our Summary Conflicts Policy, available on our website.