How to use the ATR indicator in trading?

The ATR (Average True Range) is an indicator that was created no less than in 1978, again by the trading legend J. Welles Wilder, in his legendary work “New Concepts in Technical Trading Systems”, together with the RSI, the parabolic SAR or ADX.

Even having been created so long ago, the ATR is still one of the best known indicator of the trading world.

But do not think it is a typical indicator that will give you signs of purchase or sale.

No, this is a special indicator.

Special because it is an indicator that we can use to measure volatility, an extremely important concept in the world of trading and that you will have to master if some day you want to apply valid strategies in it (about this later).

How is the ATR (Average True Range) calculated?

As you can see in the name, it tells us: “The true Range Mean”.

The “true range” already tell us that we are looking for a kind of ratio, a measure that gives us a kind of degree.

atr indicator
Case 1

This “range” would be the volatility in the movement of the product to analyze.

This ATR would be the maximum of the following ranges:

  1. Current maximum minus Current minimum
  2. Current maximum minus Previous closing
  3. Current minimum minus Prior closure

As we can understand these results we could give negative numbers but they will be given in absolute values, because what we are measuring here is a force, not an direction.

The most common case, especially if we use this ATR in hour or minute charts, which in the end is the one that we will use most commonly in trading, is the first, that is, the maximum of the period minus the minimum of the period, so that the ATR would come out as the total variation that occurs in the current bar or candle.

Case 2

The other two cases will not occur in most markets that have continuous periods, such as 5-minute charts of most instruments and, of course, Forex and cryptocurrencies, which always quote “followed”.

Cases 2 and 3 are designed for large market gaps.

And where do those gaps occur?

In stock markets, where we have that quotes are usually during the day closing at 4, 5 or 6, depending on the market.

That way we have that the shares do not negotiate for almost two thirds of the day.

Well, in those hours often produce many announcements of unexpected results or news, as we are used to, for example, Elon Musk.

Case 3

With these news prices vary enormously but are not reflected in a continuation in the graph, but we will see its consequence at the opening of the next day.

An example of this we have in the actions of Facebook a few months ago.

But well, this should not worry too much because as usual the broker or graphics provider that we use will provide the ATR in the graph of our asset to monitor, as in the case of Metatrader 4, TradingView or ProRealTime.

Now come the important thing.

atr stock market gaps
Notice the increase in ATR due to the gigantic gap in Facebook

How can we use the ATR (Average True Range)?

Well, obviously, as a measure of volatility.

And what does that help me?

Well, a lot, because depending on volatility maybe you should adjust your loss and profit objectives, something that becomes of dramatic importance when we change assets.

But before going to this, let’s see which period is the most suitable for the measurement of volatility.

According to the standards of the data providers, the typical period is 14.

Does that mean we have to use that period blindly?

Absolutely not.

150 or 14 ATR?

You can take 300 periods, 200, 100, or as many as you want.

In my case, when I see this indicator, I tend to take longer periods, such as 100, 150 or 200, which would be equivalent to the typical periods of long-term moving averages that many stock market experts use.

As we see in the IBEX 35 chart, when we choose the 150-day period it gives us a much smoother ATR than if we take the typical 14, which looks more like the profile of several mountain stages of the Tour de France.

So, the issue is in why we should use this indicator.

What is the ATR for?

I’ll explain how I use the ATR for trading.

We are trading in an asset, for example the EURUSD.

ATR
ATR in Forex EURUSD

Imagine that I have a level of stop “x” and a level of benefits “y”.

If I look at the 50-period ATR of the EURUSD we have about 81 pips.

81 pips between 113 that has the price today (1.13), gives us a 0.71% daily movement in the EURUSD.

What does this mean?

That the price moves in an average of 0.71% on a daily basis, certainly an asset that is not too volatile.

Let’s say that this system suits me and I want to apply it to other assets.

In this case, for example, Bitcoin.

atr bitcoin
Volatility is much higher in criptos

In this case we have an ATR of 240, which for the current Bitcoin price (4.150) gives us a 5.7% volatility in the asset price.

In this way we see that the Bitcoin volatility is 8 times higher than the EURUSD.

Can we operate in the same way in one and another asset?

Of course not, not to mention that the spread is going to indicate that the cost of operating bitcoin is much higher than operating the EURUSD.

For example, if that “stop x” of the EURUSD supposed 0.25% of the price (28 pips), then in Bitcoin we would have to use a stop of plus or minus 2% of the price of the asset, which in this case would be about $ 80 (rounding).

It is simply that.

Now, this is for an equivalent trading system.

Other trading systems with other stops H, J, or K, will give us different equivalences.

What I want you to see is that the ATR can serve us as a barometer when applying systems to very different assets.

Volatile markets and the meaning for trading and investing

As we can understand, the ATR will also show us very high levels when we are in a very strong bear market, such as the period from 2008 to 2009 on Wall Street.

In that way, we can also see that the assets are changing their long-term ATR when we have important events in the market, such as a recession in the stock market or a dramatic downward oil market, for example.

Thus, in an equivalent way to the previous example, we could think that we can apply not only variations in our systems when we change assets, but also when we change volatility.

Rest assured that it is not the same to operate with an ATR of 12 with the SP500 in 1,500 points than with an ATR of 40 with the SP500 in 800 points. Then the thing gets serious.

Thanks for reading the article and good trading to all.

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