Have you ever wondered how to use volatility in your trading? How to apply some filter according to its behavior? The ATR indicator can help you with this.
In this article you will be able to show you a lot of information about the Average True Range (ATR)an indicator unfairly forgotten in trading systems.
What are technical indicators and how can I use them?
Technical indicators, among which is Average True Range (ATR) is based on a series of calculations on price action (some also on volume).
I am sorry to tell you that the use of technical indicators does not always work. But they can be useful tools for spotting market entry and exit patterns.
There are quite a few technical indicators that have been developed, some show us when the market enters an overbought or oversold situation, others show us when a trend can be exhausted, if a movement is reliable and how much travel it can have.
The ATR shows us the existing volatility in a marketas well as its variations.
What is the ATR?
ATR is the acronym for the name of this technical indicator in English: Average True Range. This indicator was developed by J. Welles Wilder.
It is not more than one average price ranges (in fact, its name in Spanish corresponds to the average of the true range). A true range is the measure of volatility that can exist between two successive time periods (for example, two trading sessions, two weeks, two hours, etc.).
To the point, that it is a technical indicator of volatility. Volatility shows the strength that price movements have, have had and may have (based on estimates). This can be useful both for calculating risk and for filtering market entries and exits (later we will delve into the importance of all this for our trading).
The ATR reflects in a simple way the periods in which the market has behaved in a more violent way (is more volatile) and if the volatility increases or decreases.
How did the ATR come about?
Wilder, the creator of this and other technical indicators (such as the Relative Strength Index; RSI or the Parabolic SAR, among others), was a commodity market operator.
This trader used financial futures for his operations. Futures are leveraged instruments (just like Forex and CFD trading) and are therefore highly sensitive to strong price movements. For this reason, he discovered that it would be convenient to have a tool that would allow him to know what is the range in which the market can move in a day.
However, it may be that the market opens at a different price than the previous session’s close (known as a gap) and does not move much further during the current day. In this case, the behavior in one day is not very volatile, but if we take into account the variation from the previous close, there may actually have been volatility.
For this reason, Wilder developed a calculation formula that would allow not only seeing the volatility of a single day, but in contrast to the previous day. Similarly, by setting a mean over this calculation, you can see how volatility in the market evolves over a period of time.
His idea, which is still in force, was that after a period of high volatility it was followed by another of low volatility; and vice versa.
All technical indicators developed by J. Welles Wilder can be found in his book “News Concepts in Technical Trading Systems” (published in 1978).
How ATR – Average True Range is calculated
Like all other technical indicators, the Average True Range (ATR) is based on calculations of past price movements.
To calculate this volatility indicator we must start from the True Range of the current period (True Range). You must also configure the periods that will be taken as the basis for the calculation (that is, the number of immediately previous candles or bars taken into account).
As a general rule, the period used is 14 (they can be daily, weekly or monthly periods). Wilder, its creator, used this value for its development (moreover, on a daily basis). However, there are traders who use a very different operation from that of the father of the ATR and for this reason the period is configurable.
Find true range (True range)
As I mentioned before, the ATR indicator is nothing more than an average of the true range calculated over the indicated periods. It is taken as a value to define the range (True Range), the higher value of these three:
- The maximum price of the current period – the minimum price of the current period
- The maximum price of the current period – close of the previous period.
- Close of the previous period – the minimum price of the current period.
The difference between the prices (in other words, the range of movement they have had) shows us if the market has been more or less volatile. The larger the range means the larger volatility has existed.
Thus, the true range includes any gaps that may arise in a market. This price difference, when taking the trading session change, better reflects the strength of the oscillations and helps us measure volatility in a more reliable way.
As a last point, by creating an average over these values, we can observe the volatility variations. In other words, if it goes up or if it goes down.
Calculation of the ATR indicator
The formula for calculating the ATR indicator is as follows:
ATR= [(ATR anterior * n-1) + Rango Verdadero del período actual]/n
- where n is the current period.
In any case, the default configuration of the ATR, which Wilder left us, was carried out over a period of 14 days. As we have previously commented, the periods are taken on a daily basis (ie, to calculate the ATR we take the price movements of the previous 14 sessions).
In this way, the original ATR would look like this:
ATR= [(ATR período
anterior *13) + Rango Verdadero del período actual] /14
Despite the fact that this is the formula that its creator used to operate in the commodity market and know its volatility, the ATR can be configured according to the market, your trading style (scalping, swing, etc.) or strategy that you can use.
Graphic representation of the Average True Range
To make it easier to use the ATR indicator, it is displayed graphically at the bottom of our stock chart (although there are platforms that allow it to be placed at the top).
The vast majority of trading platforms have this indicator and you just have to select it in the corresponding section and insert it. They also allow you to configure the number of periods over which we want to make the calculation.
The ATR is represented by a linear graph, in which you can see the peaks and valleys of volatility. Increases and decreases in value are seen at a glance.
The ATR has different uses in our trading. It can be useful for both design strategies as for gauge risk. As I mentioned at the beginning of this article, it is one of the most useful technical indicators, but, curiously, one of the least used.
Some of the uses that we can give to the Average True Range (ATR) are:
- To calculate the position size in our trading account: by dividing our risk based on the existing volatility (taken as a multiple of the ATR), we are able to limit the size of our trade.
- Define stop loss level: This is one of the most widespread uses of the ATR indicator. Sometimes you do not know if the stop loss order is very adjusted to the price. Volatility can give you the answer. Knowing how violently the financial asset can move, we can calculate a safety margin to place our stop.
- Pin up profit targets: in the same way that we can limit the risk based on the potential range of movements in prices. The ATR indicator will be useful to determine how far a movement has traveled. In this way we will have an idea of what we can earn with an operation and set our take profit order.
- To create break-based strategies: when the price crosses a trend, a channel, a support or a resistance we must ask ourselves is this breakout reliable? If the price breaks out strongly, that is, with an increase in volatility, the more likely it is that the breakout will be valid.
- Select assets to trade: with the ATR you can create a filter to select which assets to trade. You may want to exclude those where volatility has been low and an explosion in price is expected. Those assets that have excessive or very low volatility can also be discarded. To be able to compare between the volatility of the assets, you just have to divide the ATR by its price and obtain a percentage (multiply it by 100).
Most frequent strategies using the ATR
Another of the most common uses of the ATR is to use it as a criterion or filter within our trading system. For example, we can define that market entries occur “when the volatility is greater than…” (usually a multiple of the ATR is taken).
The ATR can tell us a change in the direction of prices. Uptrends tend to occur in a less volatile fashion than market declines.
In case of applying it in an uptrend (long) and there is an increase in volatility, it is possible that a possible increase in panic will come forward and, therefore, there will be a change in the direction of prices.
Similarly, it is possible to exploit a downtrend that is ending if we see a drop in volatility.
A trading system could be, for example, combine the ATR with Bollinger Bands. If the price reaches the upper band and there is an increase in volatility, we may be in for a move.
On the contrary, given that price declines occur with greater volatility, when the price reaches the lower band and there is a decline in the band, it could be interpreted as the end of the decline.
As always, this should be seen through a backtest. But I already anticipate that some of my strategies use the ATR as entry and exit criteria.
supports and resistances
This strategy has been exposed previously when talking about the uses of ATR. However, it should be remembered that a strong price movement is more reliable, since it better reflects market sentiment.
The support and resistance breakouts must be validated and this indicator can help us confirm it.
As you will have seen, the ATR (Average True Range) is a complete technical indicator that can be useful for exploiting inefficiencies or improving your trading systems. Volatility is one of the most important aspects of the market and it should be taken into account in your strategies.
The ATR indicator can be incorporated into other systems and strategies. But, it can also be an important element for dDetermine the risk and establish its correct management.