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How the ATR Indicator Can Improve Your Trading Acumen

How the ATR Indicator Can Improve Your Trading Acumen

calendar 02/04/2024 - 08:45 UTC

Schoolteachers know they need to assess the moods of their pupils very quickly. Sometimes the children are over-excited; sometimes they’re lethargic; and sometimes they’re just a bit more reactive than normal, both for the good and the bad. Financial markets, which are also made up of human beings – just slightly older ones – also experience days of above-average volatility. And, in a very similar way, it can be helpful to traders to know when those days occur. When a breakout in prices occurs on such a day, whether up or down, it’s likely to be considerably sharper than normal. This can be of enormous assistance in guiding traders in setting the appropriate deal size, finding the proper entry point for their deals, and knowing when to close them too.

The tool in the trader’s chest that’s suited to gauging relative levels of price volatility is called the ATR (Average True Range) indicator. Some traders neglect to use it because the lion’s share of their time is taken up in applying the better-known indicators, but there’s a lot to be said for the ATR: It’s straightforward to understand by almost any standards, so you won’t require a PHD in astrophysics in order to learn how to use it. And, most importantly, it can give you an insight into the dynamics driving prices that other indicators simply cannot. In this article, we’ll familiarize you with the precise ATR meaning, but also with some strategies that make practical use of it in better managing the terms of online trading deals.


Patterns in Volatility

Experts agree that the volatility of financial markets appears to follow patterns, rather than to operate randomly. This means that, if we look at an asset’s volatility within a two-week period and note that it is below the norm, there is reason to believe that it will probably, at some point in the near future, shift back to a higher volatility. When it does, the change won’t, in all likelihood, happen in a chaotic fashion but, rather, it will take the form of a recognizable wave. In other words, overall volatility will rise by a notch for a certain period of time.

This is all wonderful news for financial traders because, if they could figure out how to know a low-volatility period when they see one, they would then have reason to expect a sustained change to higher volatility. Once they saw the actual change start to happen in their price charts, traders could structure their deals in such a way as to benefit from their new knowledge. You might ask: “But how could they reap any benefit from simply knowing volatility is on the way, since they have no special knowledge of the direction prices will jump in?” We’ll get to that later on but, for the moment, let’s explain how traders are able to identify unusually low volatility levels at all.


The Meaning of ATR

Take 14 days-worth of price data for your instrument consisting of three values for each day: The highest price for the session (H), the lowest price (L), and the previous day’s closing price (Cp). For each of the 14 days, (a) subtract the L from H, (b) subtract Cp from H, and (c) subtract Cp from L. When it comes to (b) and (c), your result may go into negative values but that’s okay: just ignore the minus and write down the digit. Now looking only at day one: Choose the highest of (a), (b), or (c), and then do the same for the next 13 sessions. The list you will have before you is a measure of how much prices fluctuated within each of the 14 sessions, and the name for each of those values is Tr (True Range).

Let’s imagine that, when you take all 14 Tr values and add them up, you come up with the figure of 17.64. Divide 17.64 by 14 and you’ll get 1.26. This means that the average volatility prices experienced within each of those 14 days was $1.26, and this is what we call the ATR.

By this point, the hard work has already been done. You have figured out that, in each of the last 14 days, prices for your instrument wavered within a range of $1.26 on average. Now, when day 15 ticks by, you can update your ATR in the following way: Multiply 1.26 by 13 and add to it the Tr for day 15, which we’ll put at $1.24. Divide the result by 14. In our case, you’ll come up with a result of 1.26, which means that the new Tr for day 15 didn’t change the ATR for your instrument, since it still holds at $1.26.


ATR Trading

Now then! What can we do with our new information? A fresh trading day begins, with prices on your instrument starting at $18.20. We know that, if we add 1.26 to this price, we’ll arrive at a figure that corresponds to the average upward volatility your instrument tends to experience. The result is $19.46. In the event prices rise higher than this today, we can know they’re seeing unusually high volatility. Similarly, if prices drop below $16.94 (18.20 - 1.26), we’d be seeing exceptionally high downward volatility.

One thing we could do is simply monitor prices to see if they breach those key levels. At 3pm., we notice prices jump up to $19.49. This could be a good buy signal for us because, since we’re seeing volatility shift to an unusually elevated level, we could reasonably surmise that prices will enter into an uptrend. Therefore, we may choose to open a buy position on our asset soon after the $19.49 mark is reached.

If it were true that, in previous trading sessions, price volatility had been particularly limited, with prices languishing in a very narrow range, today’s breach of the $19.49 level would be an even stronger reason to expect a new era of heightened volatility. As we have said, prices go through periods of low and high volatility in regular patterns. Low volatility periods give way to periods of increased volatility, and so on. In this case, our buy signal would really be a reason to raise an eyebrow.

In the chart below, you can see the ATR indicator at the bottom of the screen, with its 14-day span, showing how average volatility for that period shifts as the months pass by. Observe that low and high volatility periods tend to alternate one after the other, with the high levels recorded in mid-August followed by a drop in early October, and then another jump as November reaches its end.

The ATR can also assist us in figuring out when we should close our deal. Let’s say we opened a buy deal this morning based on some technical analysis we did on our instrument’s late performance. Again, prices start at $18.20 and do, in fact, start to climb. However, at midday they rapidly change course and start dropping until they eventually breach the $16.94 mark. It sounds like a good idea to close our deal because the downward volatility we’re experiencing exceeds what could normally be expected. Despite the conclusions we made from our technical analysis, it appears prices were really due to shoot in the bearish direction, not the bullish.


Using ATR Trading to Set Stop Loss Orders

Forex traders who always set their stop loss orders a fixed number of pips away from their pairs’ opening prices can tend to run into problems. Different assets are subject to different volatility levels, so, if the market waters are normally choppy for an asset, these traders might find their deals repeatedly stopped out before they can get going. This led some strategists to the idea that a stop loss could be set at a pre-determined percentage of ATR away from the entry price. So, for instance, if the ATR for your currency pair is 120 pips, you may want to set your stop loss 12 pips below the starting price. This way, your stop loss is actually in touch with the level of volatility your instrument tends to experience, rather than acting automatically and identically in every single case.


Signing Off

From what we have said, it should be clear that the ATR does not have the power on its own to tell you that a price trend is about to stop and reverse. Rather, when we take the ATR for our instrument and compare it with previous readings, it can hint to us that a trend is soon due to change. We will need to use other indicators to determine when this change is most likely to occur, what direction it will go in, and how large the change will be.

Still, the ATR can be a valuable friend to a trader. Schoolteachers know that every detail they can pick up about their pupils’ moods could give them a crucial edge when it comes time to face off with them in the classroom. Financial traders should be equally as eager to understand the nuances of their instruments’ behaviour.

The materials contained on this document should not in any way be construed, either explicitly or implicitly, directly or indirectly, as investment advice, recommendation or suggestion of an investment strategy with respect to a financial instrument, in any manner whatsoever. Any indication of past performance or simulated past performance included in this document is not a reliable indicator of future results. For the full disclaimer click here.

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