ATR Indicator Explained
ATR Indicator Explained
“Letting your emotions override your plan or system is the biggest cause of
failure.”,
J. Welles Wilder
After reading this article on the ATR indicator, a trader will find out that:
Originally developed by J. Welles Wilder, American mechanical
engineer, in his book „New Concepts in Technical Trading Systems“
Potential of confirming reversals
Calculation of ATR Indicator
Using for risk calculation and position sizing
The Average True Range (ATR) is a simple yet very effective technical
indicator, developed by the American
mechanical engineer [Link] Wilder. In
his 1974 book „New Concepts in Technical Trading Systems“, Wilder featured
the Average True Range indicator. He also developled other extremely
popular technical indicators, like the RSI, Parabolic SAR and the ADX
(Directional Movement Concept).
Originally developed for stocks and commodities, this indicator can also easily
be adapted to Forex. The ATR indicator provides an indication of price
volatility in absolute terms, as Wilders was not interested in price direction for
this indicator. Wilders recommends using a 14-period ATR on a daily time-
frame. Simply put, a currency pair which has larger movements
and higher volatility, will also have a
higher value for its ATR reading. On the other hand, a currency pair which is
trading sideways will have a lower ATR reading. These values are of big
interest to traders, as they can easily gauge the price volatility and make
better decisions about position sizing, and the size of stop loss and limit
orders. In some cases, the ATR can be used as a confirmation for bullish or
bearish reversals. A growing ATR value in the beginning of a possible reversal
might be used as a confirmation signal, as it shows rising momentum of long
or short positions.
The Average True Range calculation is based on the N-day moving average
of the true range values for a given currency pair (or other financial
instrument).
The True Range is a concept Wilders described as the highest value of the
following:
The current High minus the current Low
The absolute value of the current High minus the previous Close
The absoulute value of the current Low minus the previous Close
This concept is introduced because Wilders was interested in the price
volatility of commodities during the development of the ATR indicator. As the
trading volume on commodities is usually very low and thus price gaps often
occur, simple volatility calculations based on the current Highs and Lows did
not give adequate results. Instead, using True Ranges for volatility
calculations, which take into account gaps from previous sessions, give much
better results.
For example, if the current High is above the previous Close, and the current
Low is equal or below the previous Close, then the current High minus Low
will be used as the True Range value, that is method (a). On the other hand, if
the current session opened with a gap or the current session is an inside bar,
then methods (b) or (c) will be used, whichever is larger.
In the graphic above, the first price pattern shows a gap from the previous
Close, and method (b) will be used for the True Range calculation. The
second price pattern shows a gap to the downside, and therefore method (c)
will be used. The third price patter shows an engulfing candlestick, with highs
and lows outside the previous bar. Method (a) calculates the True Range in
this case.
As said before, the recommended period for the ATR indicator is 14 days.
This means, the value of the ATR will simply be the moving average of the 14
previous days.
Based on this statement, the acutal ATR is calculated using the following
formula:
The current ATR value is equal to the previous ATR value multiplied with
period-1, and added to the current True Range value. The result is then
divided by the current period.
As we need a beginning value for the ATR, the ATR for the first 14 periods
(assuming our ATR period is 14 days), is simply the average of the sums of
True Ranges for the first 14 periods. The actual ATR formula shown above is
used on the beginning of period 15.
Let’s take an example of the EUR/GBP currency pair:
As can be seen on the above graphic, the True Ranges for the first 14 periods
is calculated using one of the three mentioned methods above (a, b or c), and
the actual ATR formula is used beginning of the 15th period. Although this is a
relatively small sample, the purpose is purely to demonstrate the calculation of
the ATR.
ATR is widely used for position-sizing. A currency pair (or other financial
instrument) with a higher volatility and higher ATR, will require a larger stop-
loss level than a currency pair with a lower ATR. The usual stop-loss level
determined by this strategy is the current ATR level. Putting a stop-loss which
is too large on a currency pair which has a low ATR, would create
unnecessary risk for the trader. The opposite applies to currency pairs with
high ATR readings. In this case the used stop-loss and take-profit levels
should also be wider, as the position is on risk to be closed too early due to
price volatility.
In general, the greater the ATR for a currency pair the wider the stop-loss
level should be.
As ATR uses True Ranges for its calculation, which are in turn based on
absolute price changes, ATR reflects the volatility of a price not in percentage
terms but in absolute price levels. This means, a currency pair which usually
has a high exchange rate (like GBP/JPY for example), will also have a higher
ATR than a currency pair which trades on a lower exchange rate. These
makes ATR comparisons
between different currency pairs nearly impossible.
EXAMPLES:
#1 DAX Example
Let’s say you are going to execute a long trade at a certain point. You use the
ATR indicator when determining where to place a stop-loss. Depending on
which currency pair (or other instruement) you are trading, your stop-loss is a
miltiple of the ATR. Let’s have a look at a specific example. This example is
taken from a long entry on DAX. Let’s say that you enter in al ong trade at the
circled area. Where would you place your stop-loss? Different traders use
different settings, but a common approach is to take 1.5Xmultiple of the
current ATR indicator reading. In the example below, the current ATR reading
is 240. A trader using a 1.5X multiple willplace a stop-loss at 1.5x 240= 360
pips.
#2 EURUSD Example
In the second example, there is the EURUSD daily chart. Let’s say that in the
beginning of march, we took this trade that is encircled. At the time of the
trade, the ATR value was about 0.0080, which is the equivalent of 80 pips.
Let’s say that you wanted to place a stop-loss- how much would have been
that if you were using 1.5x multiplier? Yes, that would be exactly 120 pips.
You need to experiement and see which vlaues work best for the instruments
that you are trading.
#3 AUDUSD Example
In the last example, I am showing a short trade on the AUDUSD. The ATR
Indicator is showing a reading of 110 pips. You can see that the encircled
area is between 0.0100 and 0.0120. This means that if a trader is about to
take a short trade(and consider the 1.5X multiplier), the stop-loss should be
placed 1.5x110pips= 165 pips away. In order to find a right combination, a
trader must backtest and see what works best for a particular instrument.
Therefore, it is essential that a lot of experimentation is performed before
successful implementation.
Conclusion
The Average True Range is a highly popular technical indicator which
measures price volatility. ATR does not take into account the price direction,
but can be useful in case of major bullish or bearish reversals. A growing ATR
value just after the start of a potential reversal might be used as a
confirmation signal. ATR indicator is widely used for risk calcualtions and
position sizing. A currency pair with higher ATR readings require wider stops
to be used, as price volatility can easily close an initially profitable position.
Happy Trading,