Average True Range Beginnerโs Guide: Master ATR For Every Trading Strategy
Today, weโre going to talk about the Average True Range (ATR) and why it might be a good idea to start using it.
Should we use indicators or not? This question refers to the opening phrase โto be, or not to beโฆโ in Shakespeareโs famous play of Hamlet.
First of all, Trading Strategy Guides recommends keeping trading simple. That means that over-combining too many indicators is just not effective and efficient.
Secondly, some indicators have more value for certain types of strategies, and hence, using a few indicators when used properly and within the TOFTEM model actually improves a traderโs decision capabilities.
The decision of which indicators to actually use and which ones to skip is not an easy path. There are tons of indicators available and even more so created each week. How does a trader even start the process of evaluating each and every one?
It is a daunting Herculean task.
Before we begin, thanks for visiting Trading Strategy Guides (TSG)! We are so glad youโve found us. You have discovered the most extensive library of trading content on the internet. Our aim is to provide the best educational content to traders of all stages. In other words, we want to make YOU a consistent and profitable trader.
If youโre a brand new trader, we recommend hopping over to our ultimate beginnerโs guide to trading to learn more.
Many traders do opt for trading โnakedโ and solely using price action (momentum) and/or candlesticks for their trading decisions. Other traders wind up using over a dozen indicators or more when making their trading conclusions (causing paralysis of analysis).
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However, there is good news tooโฆ Trading Strategy Guides is here to help!
We highly recommend using a simple tool called the ATR โ Average True Range.
Intro: average true range (ATR)
For a clear explanation of what the ATR is, how it is calculated, and how to use it, itโs recommended to check out โusing the average true range profitably.โ It explains the basics of its composition, so I will not repeat those lessons here but instead dive into why and how using the ATR is beneficial for your trading.
The Average True Range (ATR) is one of those rare, best Forex indicators that you always want to have on the chart because it provides vital information about the probability and likelihood of the market approaching or hitting your exits, which is either stop loss or take profit.
Knowing if your exit is within the marketโs range is important information because the exit of a trade will determine whether a trade is a profit or a loss โ not the entry. Winners Edge has written several blog posts on the topic before, such as:
- Avoiding early exits is easier than Forex traders think;
- Two methods for improving FX exits;
- This particular post is focusing on the benefit of ATR for the exit decision.
What Is the Average True Range Indicator?
Average True Range indicator is the average of true ranges over a specified period. Itโs primarily used to gauge the volatility of an assetโs price. Unlike many indicators, the Average True Range (ATR) doesnโt predict price direction but focuses solely on volatility. This includes accounting for price gaps or limit moves that can affect an assetโs price.
Typically, Average True Range values are calculated over 14 periods. These periods can be of various lengths, such as daily, weekly, monthly, or even intraday. The choice of the period length depends on the specific needs of the trader or analyst. For instance, shorter averages, like 2 to 10 periods, are used to measure recent volatility.
The Average True Range indicator can be a key part of trading strategies, particularly for determining entry and exit points. Since it measures volatility, high Average True Range values suggest possible trend changes or market instability. At the same time, low Average True Range values might indicate weaker trends or consolidation phases.
Moreover, the Average True Range percentage (ATRP) is another way to use ATR. Average True Range percentage represents the ATR as a percentage of the current asset price, providing a relative measure of volatility. This can be particularly useful for comparing volatility across different-priced assets.
Utilizing the Average True Range (ATR): A Strategic Edge in Forex Trading
Why use the ATR? Because (A) itโs a very helpful indicator, and (B) not a large percentage of Forex traders use it, which means that using it will give you an edge that the majority of traders donโt have. Anyway, gaining an edge in trading will improve your probability of success (i.e., making MONEY!).
Understanding the ATR as a Powerful Indicator
The ATR is a volatility measure and trading range indicator, similar to Bollinger Bands, only better. So, forget about Bollinger Bands now โ I was just trying to give you some frame of reference for understanding what type of indicator the ATR is. You can also trade with the best ADX strategy.
Welles Wilderโs Contribution: The Origin of ATR
The ATR was developed by the famed technical chartist Welles Wilder, so thatโs a point in its favor right there. Iโm pretty sure old Welles made some money in the markets. He originally developed it for use in commodity trading (the Forex market as we know it today didnโt even exist at the time), but itโs been adopted by a number of smart Forex traders because the Forex market, just like the commodities market, tends to be more volatile on a day-to-day basis than stock trading usually is.
Unlocking the Power of ATR: How to Use the Indicator
Calculating ATR: A Closer Look at the Formula
The ATR is calculated by comparing three values โ the current high minus the current low price, the current high minus the previous closing candlestick price, and the current low minus the previous closing candlestick price. Iโm not going to go into detail about how to calculate it because itโs a freely available MT4 indicator.
Ease of Use: Integrating ATR into Your Trading
You donโt have to calculate it โ all you have to do is load the indicator on your chart. It appears as a single line in a separate window, below the main chart area, and shows the range of values on the right-hand side. If you move your cursor to any point on the line, it should show you the ATR value for that point in time. And hey, you can usually โguesstimateโ the ATR value with just a quick glance at it.
Deciphering ATR Movements
The ATR moves between value points. In the case of forex trading, thatโs pip values so an ATR reading of 29 translates as 29 pips. Itโs especially helpful in picking take profit exit points for trades, although it can also be used to help identify entry points and stop-loss placements as well. You can also read about how to leverage stop loss.
Analyzing Trading Ranges: ATR in Action
Well, first of all, itโs an excellent indicator of just what its name says โ the Average True Range of trading over whatever time frame you apply it to. It gives a solid indication of what the average trading range currently is for the hourly, daily, 30 minute, or whatever time frame you choose.
Secondly, it provides an indication of whether the average trading range is narrowing or increasing. Very narrow trading ranges over an extended period of time often precede strong, extended moves in one direction or the other, up or down.
Risk Management: Placing Stops with ATR
Okay, now where do you put your stop? Well, many traders would place it at or just below the low of that blue candle that they entered the trade on. So letโs just go with that for now. Iโm not saying itโs a great idea โ Iโm just saying letโs use it for the moment.
Now letโs watch the action unfold. Initially, the market moves up a bit, but then it just sort of stalls out for several hours. Youโre not getting hurt in the trade, but the market isnโt moving higher toward your very reasonable take-profit point either. This is where it gets interesting, but not in a good way. The market begins to slide down. And where does it slide down to? JUST below the low of that blue candle, you entered the trade on. Stopped out for a small loss.
Now hereโs the part where you want to shoot yourself: Right after stopping you out, the market decides to zoom higher, taking off to where it would have easily hit your take profit target. So it turned out that your small loss could have easily been a 60-pip winner in just a couple of more hours. If only you just hadnโt gotten stopped out. Jeez, I hate it when that happens.
Traders tend to use a wide variety of tools and indicators for determining exits, but one thing that they often do not use is this:
- An indicator that identifies whether a target is realistically within reach;
- An indicator that identifies whether a stop loss is realistically out of reach;
- An indicator that identifies whether a trail stop loss has a chance of (safely) being moved without putting it needlessly in harmโs way. To know more, read about how to determine stop loss in Forex.
The ATR does all of the above. It indicates the average range of recent history and trade and can thereby judge whether the target is within the average of recent history or outside of that zone.
The following conclusions can be made:
- Stop loss is within ATR level โ DANGER: stop loss is too close to price action, and trade has too high a chance of hitting the stop loss.
- Stop loss is outside of ATR level โ GOOD: stop loss is far away from price action, and trade has a decent chance of not hitting the stop loss.
- Target is within ATR level โ GOOD: take profit or soft target is close to price action, and trade has a good chance of hitting that zone.
- Target is outside of ATR level โ DANGER: take profit is too far away from price action, and trade does not have a decent chance of not hitting the target zone.
What Is the Average True Range Indicator Formula?
The Average True Range indicator formula is a tool that is used in market analysis to measure volatility. It was developed by J. Welles Wilder and is calculated using the following formula:
In this formula:
- ATR stands for Average True Range.
- n is the number of periods or bars youโre considering. This could be days, weeks, or any other time period.
- TR refers to the True Range for a given period.
The True Range (TR) is a key part of this Average True Range calculation. Itโs defined as the greatest of the following three Average True Range values:
- Todayโs high minus todayโs low.
- The absolute value of todayโs high minus yesterdayโs close.
- The absolute values of todayโs low minus yesterdayโs close.
This Average True Range indicator formula is designed to capture the range of price movement in a market, factoring in gaps and limiting moves that might not be captured by simpler range measures.
By averaging these true ranges over a period (such as 14 days, which is commonly used), the ATR provides a smoothed measure of market volatility.
Real-world Application: Using ATR in Forex Trading
Letโs take a look at an example of using the ATR in actual trading. Check out the chart below, an hourly chart of EUR/USD. Iโve got a couple of simple moving averages plotted on the chart, and the ATR indicator appears as a blue line in the window below the chart.
Understanding Candlestick Patterns: ATR in Trade Entry
First, I want to draw your attention to an area around the middle of the chart. Itโs several candlesticks past where trading makes a short-term low. This is where Iโve marked one point on the chart with a thumbs up above the current candlesticks. Iโve also marked another point around 20 or so candlesticks later, where trading takes another dip just before surging sharply higher.
This is marked with a thumbs down below the candlesticks. At both those points, the ATR indicator is about mid-way between the two values shown on the right-hand side of the ATR window (9 and 37). The ATR at each of those points is approximately 23.
Optimizing Profit Potential: ATR in Take Profit Strategies
Now hereโs what Iโd like to point out. Letโs say you decided to buy Eur/Usd at the close โ around 1.1180 โ of the blue up candle thatโs directly below the thumbs-up sign. You can identify this as the crossover of the shorter-term moving average line (green line) moving above the longer-term moving average line (red line).
Letโs further assume that youโre not going to be greedy in this trade, youโre only going to shoot for a profit equal to approximately 2-3 times the ATR. In other words, about the highest level you could reasonably expect the market to trade within the next 2-3 hours, which is a little less than half a trading session. This is based on its recent ATR. So, you put a take profit target somewhere around 1.1240.
Also, read how currency pairs work in Forex.
Simple Conclusion โ Stay on Target
With the above ideas in mind, the conclusion becomes very simple:
To improve your exits, keep your targets within the average range and keep your stop loss outside of it.
Not many indicators can actually help assist a trader in recognizing that a target or a stop loss is in or out of range. The simplest way of doing so is using the ATR.
What do you think of theย Forex indicator, Average True Range? Can you imagine how the above ATR tactics could help improve your trading?
Thank you for reading!
Leave a comment below if you have any questions about the Average True Range (ATR) and its necessity.
How Can I Make a Profit and Stop Losses?
Trading Strategy Guides recommends using an ATR with a value of 20. When setting up the average true range stop loss, we recommend using 7 up to 12 values of ATR.
This means that a trader must take the ATR value of the entry candle and multiply it anywhere from 7 to 12. By doing this, a trader knows that they are not placing the protective stop in the middle of price action.
When setting up the take profit, we recommend using 4 up to 8 values of ATR. This means that a trader must take the ATR value of the entry candle and multiply it anywhere from 4 to 8. By doing this, a trader knows that they are placing the target in the middle of price action.
Why the Variance in Levels? (4 to 8 & 7 to 12)
There is perhaps a considerable gap between 7 and 12 for the stop loss and 4 and 8 for the target, and you might wonder why.
The market is not a rigid structure and is very dynamic. In our testing, all of these levels actually work well. Therefore, we would rather decide the multiple levels for each individual trade. How do we do that?
We use the market structure on a higher time frame to choose the best stop loss and take profit levels within the recommended zone. Because the entire zone is good, we can use our discretion within that zone to optimize our results.
What I mean is that a trader can use 4-hour and/or daily tops and bottoms for placing stop losses above resistance or below support, where placing targets below resistance and above support for further refinement of their edge.
hi Chris, and 10x for the article.
the levels you suggest to apply for tp and sl are a bit strange to me: if i understand correctly, the trader following 4-7 for tp and 7-12 for sl will have poor rr ratio, or at best 1:1 if multiply atr x 7 for tp and atr x 7 for sl /which will lead to the same pips though and sl will be in the rangeโฆ
do i get it right, and if so isnโt this a way for taking more risk for sl in a trade?
i do like the tp option within the atr range /explained perfectly in the article/, but the sl is just too far, meaning if smtg goes wrong the account will suffer big time
10x in advance for ur answer
Hi Georgi, thanks for the feedback and comment! Glad you find the post helpful. Yes the reward to risk ratio is not going to be very high, but it will be compensated by a higher win percentage. It should be noted though that you do not want to aim for 4x TP and have 12x SL because then the R:R is too low (0.33:1). So you want to keep a balance there. Anything from 0.5 or higher is ok. Preferably though we aim for 0.6 as the minimum. If you get close to the 1:1, the better it is. In some cases we even go above 1:1 because we enter at a discount compared to our trigger, so then we might a TP of 9x ATR (instead of 6) and a SL of 7x ATR (instead of 10), making it 1.28 R:R instead of 0.6.
10x for ur answer. i will implement the atr in my trading.
recently read another article for atr, basically sayng this:
atr 20, daily
taking 50% of the sum high+low atr
on 4h chart, add the pips from the above point over prev daily close
on 4 h chart subst pips from prev daily close
this range is the most likely for the day
for example 100 pips over and 100 pips below prev day close
follow the price movement
no big news or data
if pair moved already for ex 80 pips in the above or bottom part of range, it will remain there, because it is most likely to move arround another 20-30 pips or so
this combined with stoch for overbought or overselled pair
makes sence, but this way a lot of the movement will be lost
haw can you comment this?
Hi Georgi, most welcome! Not an easy one to judge as I have never used this technique. I could imagine that adding pips to the previous day high and low via the ATR value could make sense. Its not clear to me how it would be used for taking tradesโฆ but I can imagine its use for taking profit or placing stop losses.