Average True Range
The Average True Range (ATR) is an indicator that was developed by J. Welles Wilder, Jr. who introduced it along with a few other indicators (Parabolic SAR, RSI and the Directional Movement Concept) in his book, “New Concepts in Technical Trading Systems” in 1978.
The ATR was originally designed by Wilder to appropriately measure the volatility of Commodities, an instrument that typically has gaps and limit moves that occur when a commodity opens up or down its maximum allowed move for the session.
Today, the ATR may be one of the oldest indicators that exist but it is far from being obsolete. What’s very interesting about this indicator is its universal and adaptive nature. That’s why it remains applicable and popular among good trading systems and is used with a wide variety of instruments.
Many trading systems use the ATR as an essential tool for measuring the volatility of the market. The Average True Range reveals the volatility in a particular instrument but it does not indicate the price direction.
Any trader who is keen on designing an excellent trading system should be familiar with the Average True Range and the many ways it can be used to improve the performance of any trading system.
The ATR has numerous functions and it’s generally applicable in finding trade setups, entry points, stop loss levels and take profit levels with reasonable money management technique.
Definition of Terms & Related Concepts
Before we proceed, let’s define a few terms that we will be using frequently as we talk about the Average True Range…
Average True Range (ATR) is an indicator that measures volatility. It is a “moving” average of the true range for a specific given period.
Volatility is defined in terms of market action. An active market is said to be volatile while an inactive market is considered non-volatile. Volatility is directly proportional to the range, so if range increases, it also increases. If the range decreases, so does the volatility of the instrument.
Range is the distance that the price moves per increment of time. It is the distance from the highest price to the lowest price of the day, in other words, equivalent to the height of 1 bar or candlestick. It is calculated by taking the difference between the high point and the low point.
However, if the current candle is a Doji where the price does not move at all, the real price range is actually the distance from the previous close to the open price of the Dogi (current candle). Also, if the close of the previous candle is not within the current candle, the range begins from the close of the previous candle.
It follows that the True Range (TR) is the maximum range that the price has moved either during the current candle or from the previous close to the highest point reached during the candle. True Range is defined as the greatest distance of the following:
A. Current High to the Current Low
B. Previous Close to the Current High
C. Previous Close to the Current Low
Absolute values will be used for the calculations to get the distance between the two points. This is because the aim is to get the distance and not the direction. The first range will be used for the calculation of the initial True Range. We will talk more about that in another section.
According to Wilder, you must consider the value of the range for a number of periods in order for it to be a useful tool to measure volatility. This is why an average of the true range over a number of periods must be obtained. A sufficient number of periods must be used to provide sufficient sample size to obtain an accurate indication of an instrument’s price movement. He considers 14 bars to be the best indicator of volatility and uses it for his Volatility system. You will know more about this system as we go along.
Here is how the ATR looks like when applied on your chart:
To get the Average True Range (ATR), the average of the true ranges of a number of periods of data is computed. The number of periods affects how adaptive the ATR is to recent changes in volatility. For instance, a shorter average of 10 bars makes the ATR more reactive to the current price range and thus has more fluctuations as compared to a longer average of 20 bars that will show a more stable ATR.
The ATR is usually based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. We will use 14 periods as our example for the computation.
The computation of the initial Average True Range (ATR) differs from the rest of the ATRs.
Please refer to the following table for our discussion on the computation:
CH – Current High CL – Current Low
PC – Previous Close TR – True Range
ATR – Average True Range
Step 1: Compute for True Range value for 14 days.
The first True Range (TR) value is obtained from only 1 period and it is calculated by deducting its Current Low to the Current High. The rest of the TRs will have a value that is the greatest among the 3 computations as defined.
TR for day 1 = Current High – Current Low
TR1 = CH – CL = 1.36164 – 1.36050 = $0.00113
TR for days 2 to 14 will have the greatest value among the following:
TR = Current High (CH) – Current Low (CL)
TR = Current High (CH) – Previous Close (PC)
TR = Current Low (CL) – Previous Close (PC)
TR6 = CH – CL = 1.35959 – 1.35699 = $0.00260
TR9 = CH – PC = 1.36190 – 1.35490 = $0.00700
TR11 = CL – PC = 1.36098 – 1.36381 = $0.00283
We use the absolute values because as mentioned earlier, the aim of this computation is to obtain the distance regardless of the direction.
Step 2: Compute for the Initial Average True Range value.
The first 14-day ATR is the average of the daily TR values for the last 14 days.
= TR1 + TR2 + TR3 + TR4 + TR5 + TR6 + TR7 + TR8 + TR9 + TR10 + TR11 + TR12 + TR13 + TR14
= TR1 + TR2 + TR3 + TR4 + TR5 + TR6 + TR7 + TR8 + TR9 + TR10 + TR11 + TR12 + TR13 + TR14
= 0.00113 + 0.00084 + 0.00163 + 0.00143 + 0.00191 + 0.00260 + 0.00260
+ 0.00140 + 0.00700 + 0.00389 + 0.00283 + 0.00129 + 0.00362 + 0.00168
Step 3: Compute for the Average True Range value for the rest of the days.
To compute for the ATR for the rest of the days, only the information on the previous ATR is held. Multiply the previous ATR by 13, then add the current TR and divide by 14.
Current ATR = (Previous ATR x 13) + Current TR
Current ATR = (Previous ATR x 13) + Current TR
= (0.00242x 13) + 0.00397
There are 2 main reasons that made the Average True Rage (ATR) remain popularly used with many trading systems through the decades. The ATR is a remarkable measure of market price movement because it can be used across different financial securities and it also adapts to changing market volatility. Because of this, it plays a vital role in setting your stops or take profit levels.
Useful Across Different Financial Securities
A system that can only be used to trade in one market can be used to trade other markets just by changing the way the calculations are expressed. Using units or multiples of ATR instead of using definitive values such as dollars, points or pips can turn any simple system into a universal trading system.
One of the most common uses of the ATR is setting the stop loss level. Below is a typical scenario of how the ATR can be applied to set your stop for different financial instruments.
Imagine that we are using a simple system to trade with 2 different instruments, a currency pair (A) and a commodity (B). Given that A’s ATR is $0.0020 and B’s ATR is $300, the huge difference between the volatility levels would require us to set 2 different stop loss levels. For instance, our stops may be $0.0030 for A and $450 for B.
On the other hand, if we use values in units or multiples of ATR to set our stop loss for our system, we will need only 1 value to compute the stop loss level for both markets. We can set our stop 1.5 ATRs from the entry price. A’s stop loss level would still be $0.0030 (computed from 1.5 x $0.0020) and B’s stop loss level would also be at $450 (computed from 1.5 x $300).
Adaptive To Changing Market Conditions
Substituting units or multiples of ATR to the usual dollar, point, pip or whatever units of measure used in your system can make it remain applicable in the long run without reoptimization despite any changes in price movement or volatility.
We are well aware that market conditions and, consequently, price movement or volatility, can change and will change either abruptly or gradually. Since the ATR changes in direct proportion to changes in volatility, it can easily bring your stop closer or farther to allow enough space for price movement normally expected for that particular volatility level. Unless the market has changed in direction, you will not be stopped out.
Here’s a typical scenario to prove this point…
If the market quiets down and the ATR of A changes to $0.0010 and B changes to $150, the $0.0030 stop for A and $450 stop for B are now too far, causing you to lose an unnecessarily large amount from every single trade. Similarly, if the market becomes extremely volatile and the ATR of A increases to $0.0040 and B increases to $600, the $0.0030 stop for A and $450 for B are now too close, causing you a higher percentage of losing trades. We need to reoptimize our system to suit the current market conditions.
On the other hand, if we substitute units of ATR to the amounts we were originally using as our stop, our system would greatly improve. When volatility changes, our stops would automatically adjust to accommodate the change. So, if the market quiets down and the ATR of A changes to $0.0010 and B changes to $150, our new stop for A would be $0.0015 (computed from 1.5 x $0.0010) and our stop for B would be $225 (computed from 1.5 x $150). Similarly, if the market becomes extremely volatile and ATR changes to 40 pips, our stop would now be at 60 pips (1.5 x 40).
Notice that the stop loss level is adjusted automatically even if we are still using the same stop loss value which is 1.5 ATR. Our improved system is still applicable and there is no need for reoptimization.
That is the essence of using the ATR in any trading system. Because it can adapt to change and can be used with different markets without altering its value, it significantly cuts off a big chunk of hard work when looking into different markets and its accompanying fluctuations in volatility.
Most systems that use the ATR are applicable not only in the past and the present, but also in the future despite any changes in market volatility.
Interpreting the ATR
Now that we know what the Average True Rage (ATR) is and how it is computed, we need to know what the values of the ATR mean. Depending on its readings, the ATR can be used in all aspects of the trading process.
Low ATR Reading
A low reading of ATR simply indicates that the market is quiet and less volatile. The volume of the market is light. This may mean any of the following:
1. The market is ranging when the ATR is relatively low. There isn’t enough volatility to move the market in an uptrend or a downtrend.
2. Price has reached the bottom or top, which is eventually be followed by price reversal.
Have a look at the image below.
In the first section of the image above, you can see that the ATR is generally low and has now peaks. Notice that the market is just ranging at that time. In the rest of the sections, you will see that an uptrend has formed and every time the ATR reaches its lowest levels, a change in price direction follows.
High ATR Reading
On the other hand, an increased ATR simply indicates that the market is very active and is highly volatile. This would indicate that a much stable trend is imminent because there is sufficient movement in the market for the price to move in an uptrend or a downtrend. The ATR peaks when any of the following situations occur:
1. During a rally or a period of sustained increase in price.
2. During a sustained period of decline in price.
Take a look at the image with the peaks marked below.
As you can see, the ATR increases when the market is moving up or down and it usually peaks when a sustained movement has occurred. However, when the market makes a strong move in one direction that is stronger than the normal fluctuations above, it is assumed that a new trend is now forming (breakout).
Now that we know what the readings of the Average True Range Mean, we’ll find out how it these concepts can be used with logic in the various aspects of our trading – Entry, Stop Loss, Take Profit.
Low ATR Reading
When the ATR reaches its lowest levels, a change in price direction usually follows. Here’s how we can use this information to our advantage. When the market is trending, enter only after the price has retraced and is returning to the general trend. Here, we will buy once a retracement has ended and the price continues going up in the uptrend. Inversely, we will only sell once a retracement in a downtrend has ended and the price continues going down.
For example, a 50 period moving average (MA) is used to identify the general trend. The current close must be 2 ATRs or more than the 50 MA to ensure that the general trend is up. To ensure that we are in a retracement (dip), the current close should be 2 ATRs or more below the close 5 days ago. You will know when the dip has ended when a new candle opens and reaches 1 ATR above the previous low. The price is now returning to the general trend, and this is when you enter the buy trade. The opposite of the above conditions will be the rules for entering a sell trade.
High ATR Reading
The market usually becomes very volatile when a new trend is now forming. This is called a breakout, and we can use the ATR values to confirm it. Since the price normally only reaches up to a number of ATRs only, exceeding that level indicates that an unusual phenomenon occurred, a breakout is happening and thus the beginning of a new trend.
Here’s an example. Supposing that the price normally rises or falls 2 ATRs from the previous close, you will only buy if the price reaches 3 ATRs higher from the previous close. Inversely, you will only sell if the price reaches 3 ATRs lower than the previous close.
In the previous images, you will notice that a low ATR reading is always followed by a high reading. The ATR is cyclical in nature, increasing and decreasing alternately.
Knowing when the market is quiet is important because it means that the volatility will increase soon indicating a possible trade setup. If we want to refine our signals, we can begin with a period of low volatility and wait for an increase in volatility before looking to enter the trade.
Note however, that the ATR only indicates the volatility and not the direction. You will either sell or buy depending on the direction of the trend.
Some trading systems only place trades after the price has reached the extreme peak or extreme bottom and has reversed. Here, you will buy only after the market has reached a significant decline in price, and you will sell only after a sustained period of increase in price. As soon as the price reversed, traders wait for it to reach a number of ATRs in the new direction before entering the trade. Depending on the system, the values of the number of ATRs and periods vary.
The Average True Range plays an important role in selecting the stop loss level in a trade. It can also be used to trail your stops. One great example would be Chuck LeBeau’s famous Chandelier Exit. Here, the stop loss level is expressed in ATRs so it also adjusts to the changing market conditions. The stop loss level will be set an N number ATRs from the highest high/close for a buy trade or from the lowest low/close is reached for a sell trade. The Chandelier Exit is so called because it hangs downward from the ceiling of the market. Note, however, that the movement of the Chandelier Exit is only in one direction. It only goes up for a buy trade or down for a sell trade.
The exit rules for systems using the Chandelier Exit may let you stop your loss when the price reaches the highest high of the trade minus 3 ATRs (computed as Highest High – 3ATR) or when the price reaches the highest close reached during the trade minus 3 ATRs (computed as Highest Close – 3ATR).
The Average true range is not only used as a basis for the stop loss level, it also plays a significant role in setting the take profit level.
Our discussion on the use of dollars to express the value of the stop loss level goes the same way if we express it as number of periods or pips. Let’s apply the same principle in setting the take profit. We know that even backtests indicate that a certain value such as 40 pips is the best take profit level, it will only hold true for the time being and may need reoptimization as the market condition changes.
But again, market conditions are ever changing and degree of volatility will always change. If the markets are unusually quiet, we may not reach our 40-pip take profit level. On the other hand, if the market is extremely volatile, you can only take 40 pips even if you could have taken much more than 40 pips. Because of this, 40 pips is not an ideal measure of our profit target.
To have a more stable system, we need a profit target that can adapt to changes in volatility. This can be achieved when we express our profit target in terms of ATRs.
Here’s an example. Given that our backtests indicate that the best profit target is 4 ATRs, it is equivalent to 40 pips in normal market conditions. This time, when the market is extremely quiet, it may only be equivalent to 20 pips. On the other hand, when the market becomes very volatile, 4 ATRs may be equal to 80 pips. There is no need for reoptimization because the ATR based profit target readily adapts to the changes market conditions.
When using the ATR based profit target and the market tends to be extremely volatile, your winners will be bigger than usual because your target profit has increased along with the increase in volatility, even if you will have the same percentage of winning trades.
Just like our example earlier, when the market becomes extremely volatile, the value of our 4 ATR increases to 80 pips. We will get out with 40 more pips as compared to our usual take profit level during normal market conditions.
Setting appropriate stop loss and take profit levels are important aspects of money management that no trader should miss out.
Let me show you the difference that the ATR can make when used in a trading system. Let’s compare 2 systems with similar rules but with different units of measure. Have a look at the System 1 and System 2 below.
The systems above look similar. If the current ATR is 10 pips, you will be entered and exited with the same prices. Both systems are equally effective if only market conditions remain the same. Unfortunately, the market is ever changing and volatility fluctuates. When that happens, System 2 will still be applicable but not System 1. Let me show you what I mean…
Assuming that the market becomes extremely volatile that the current ATR becomes 20 pips, the previous ATR which is 10 pips has been doubled. Have a look at the table below to have a better grasp of the scenario.
As you can see, the entry for System 1 remains the same. With the increase in volatility, you will be entered unreasonably in too many trades. On the other hand, System 2 will give you only the entries that count since its entry has been increased because of the increased volatility.
The same holds true with the take profit level. With System 1, you will be taken out with your profit too early, and you will only get 40 pips per trade even if you could have earned 80 pips. Using System 2 will allow you to get bigger profits because the take profit level increases with the increase in volatility.
For the stop loss, System 1 will now take you out of your trades prematurely. You will be in and out of trades with losses that you are not supposed to get. In contrast, the stop loss level for System 2 is much farther. As volatility increased, the stop loss is increased accordingly to give the price enough space to retrace and go back to its original direction.
Because System 2 adapts to the changes in market conditions, we will achieve a stable win/loss ratio. In addition, our winning trades become bigger as a result of the increased take profit levels due to the increase in volatility. This goes to show that System 2 is a significant improvement of System 1.
Application: ATR-Filtered SMA System
Now you’ve seen how the proper use of the Average True Range can greatly improve a simple trading system. Let me show you how I use the ATR to filter my entries, stop loss and exit/take profit levels for a simple system with 2 SMAs. Here is my RTA-Filtered SMA System.
Currency Pair: EUR/USD
I use the 15 Minute timeframe to check for the ATR reading before finding trade setups. I also use it to enter my trades. I use the 4 Hour and 1 Hour timeframes to confirm the general trend of the market.
14 Period Average True Range (0.001 level)
8 Period Simple Moving Average (8 Period SMA)
21 Period Simple Moving Average (21 Period SMA)
Below are the Buy Trade Rules for my system. The exact opposite will hold true for Sell trade rules and will not be discussed.
1. On the M15 chart, the 14 ATR must be 0.0010 or less before looking for signals.
This indicates that the market is quiet, and a possible breakout is about to occur. I just use the 0.001 level to serve as a visual signal that the ATR has reached a low level in the EUR/USD chart.
2. Wait for the price to be above the 8 SMA and the 8 SMA to cross above the 21 SMA in the H4, H1 and M15.
I do this to ensure that I am in the appropriate trend; I will only enter a buy trade only when the trend is up.
3. Identify the most recent lowest low/swing low then add 3 ATRs to the closing price of that candle (Closing Price + 3ATR). Wait for the price to close above this level.
I can confirm that the downtrend has reversed to an uptrend if the price moves more than 3 ATRs from the lowest close. I use 3 ATRs because this is the recommended multiplier by Wilder.
4. As soon as Point 2 and Point 3 have been met, enter a buy trade.
5. Set the stop loss 3 ATRs below the entry price.
If the price moves against my favor and reaches 3 ATRs below the entry price, there is a bigger probability that the market has completely turned against me. Here, I would rather cut my losses short before it gets out of hand.
6. Exit at the open of the next candle when both conditions are met:
a. The 8 SMA crosses under the 21 SMA.
b. Price crosses 3ATRs from the highest close.
When the 8 SMA crosses under the 21 SMA, it may indicate that the price is now retracing or reversing. I use the ATR reading to confirm this, so only when the price reaches 3 ATRs from the highest close will I take my profit and close my trade.
To get a better idea, have a look at some examples in the next page.
Buy Trade Example 1:
In the image above, you can see that I started looking for the trade setup along the blue vertical line where the ATR is below 0.001 level.
The price was above the SMAs, and the 8 SMA completely crossed in the H4 and H1 at the close of the candle along the dotted green vertical line. The most recent lowest low was at 1.30899 indicated by the blue horizontal line, and the ATR level then was at 0.0010, so I computed 3 ATRs from there so that I can enter a buy trade when the price exceeds that level.
Recent Lowest Close = 1.30899
ATR = 0.0010
3ATR + Recent Lowest Close
= 3 (0.0010) + 1.30899
I entered a buy trade at the open of the candle indicated by the solid green line then set my stop loss level 3 ATRs below it.
Buy Entry Price (open of next candle) = 1.31320
ATR = 0.0010
Stop Loss = 1.31020
= Entry Price – 3 (ATR)
= 1.31320 – 3 (0.0010)
= 1.31320 – 0.00300
Later on, I noticed that the 8 SMA began to cross under the 21 SMA, so I computed 3 ATRs from the highest close to confirm that the trend was now reversing and exited the trade as soon as the price reached that level.
Recent Highest Close = 1.33783
ATR = 0.0014
Highest Close – 3 (ATR)
= 1.33783 – 3 (0.0014)
= 1.33783 – 0.0042
Exit/Take Profit = 1.33417
Buy Trade Example 2:
SMA. I entered the trade as soon as the price exceeded 3 ATRs from the close of the previous swing low.
Recent Lowest Close = 1.33068
ATR = 0.0010
3ATR + Recent Lowest Close
= 3 (0.0010) + 1.33068
I then set my stop loss level 3 ATRs below the entry price.
Buy Entry Price (open of next candle) = 1.33410
ATR = 0.0013
= Entry Price – 3 (ATR)
= 1.31320 – 3 (0.0013)
= 1.31320 – 0.0039
When the price retraced and the SMAs crossed, I computed for 3 ATRs from the close of the highest candle and exited the position when the price reached that level.
Highest Close = 1.34477
ATR = 0.0026
Highest Close – 3 (ATR)
= 1.34477 – 3 (0.0026)
= 1.34477 – 0.0078
Exit/Take Profit = 1.33720
Watch this video to see how I use the Average True Range (ATR) to my advantage in my simple trading system.
CLICK HERE TO WATCH THE VIDEO
The use of the Average True Range in expressing the stop loss levels may expose a particular position to greater risks when the volatility greatly increases. As such, it may exceed the maximum risk set by our money management. It is then advisable to have a set stop for emergency situations expressed in dollars, points, or pips. This can be used when volatility increases and the trade is in our favor.
We can also reduce the lot size to reduce the risk exposure, but do this only when volatility is increasing and the trade is going against our favor.
To maximize the profits taken per trade, you can also reduce the distance from the price to your trailing stop once you are already in a stable profit.
Supposing that your trailing stop is originally set at 2 ATRs from the high, and your profit is steadily increasing, you can tighten your stop by reducing the distance between your high/low (for a buy/sell) and the stop to 1.5 ATRs.
Indeed, the Average True Range (ATR) is a brilliant volatility indicator. It identifies the strength of the price movement or volatility. A highly volatile market is typically followed by a quiet market and because the ATR identifies when the volatility increases, it can help confirm the breakout of a new trend. Although the ATR cannot tell the direction of the market, it is still a vital tool in identifying logical entries, profit targets and stops. Aside from those mentioned, the ATR can be used as in conjunction with other indicators or as part of a trading system to help filter trade signals.
Over the decades, this unique indicator managed to not only survive but remain popularly used in many trading systems simply because of these reasons. The ATR can be used in many different ways to help make your system remain applicable despite changing market conditions. It also makes your system suitable for different financial instruments.
I hope that with this report, I was able to show you the significance of the Average True Range in trading when used properly. I suggest you try it out and tweak some settings to see what suits best for your trading style.
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