Measure Market Volatility With the Average True Range Indicator

Volatility is one of the pitfalls of any financial market. Every trader should remember that volatility always exists. The risk is its strength. If volatility is low, it’s easy to predict the price direction and determine the levels an asset’s price may reach. In periods of increased volatility, the price fluctuates within large ranges. However, there are technical indicators that help traders measure the degree of volatility. The Average True Range (ATR) is one of them. Let’s check how it works.

What Is the Average True Range (ATR)?

The Average True Range indicator was first described in the book “New Concepts in Technical Trading Systems” by J. Welles Wilder, Jr.

ATR is a technical analysis tool that measures market volatility and reflects the average size of asset fluctuations over a certain period, indicating the degree of risk associated with the price fluctuations.

The indicator can be implemented on any timeframe, from 1-minute to 1-year. It is placed below the price chart and presented by a continuous line.

How To Calculate the Average True Range

Only historical data is required to calculate the indicator. When implementing ATR on the price chart, the only parameter you should set is the period. The period defines how many of the latest bars will be calculated. The standard setting is 14. It means that the calculation is based on the value of the latest 14 bars (the bar or candlestick can reflect the price movement for a minute, hour, day, week, month, and even year).

The ATR calculation is based on true ranges. The formula is:

ATR = (Previous ATR * (n - 1) + TR) / n

Where,

• n stands for the period
• TR is a True Range that reflects the current greatest of the following:

1. Current high price minus the current low price

1. The absolute value of the current high price minus the previous close price
2. The absolute value of the current low price minus the previous close price

The 14 period mostly works for trading on the daily chart. However, if you need to measure volatility on lower timeframes, it’s recommended to use periods from 2 to 10. On the higher timeframes, you should set bigger periods from 20 to 50. The period will affect the frequency of signals. If you shorten the period, the number of signals will increase along with the risk of fake signals. A larger period reduces the number of signals but makes them more reliable.

Average True Range vs. Standard Deviation

Standard deviation is an indicator applied to evaluate and reflect the price volatility. It is often combined with other technical tools. For example, it’s usually used as a part of the Bollinger Bands instrument. Standard deviation reflects the price variability relative to a moving average.

Both the Average True Range and standard deviation indicators reflect an asset’s volatility. When the indicators rise, it’s a sign of increasing volatility. When they decline, there is a signal that volatility lowers. However, their calculations differ. Therefore, their signals are different sometimes.

As we have mentioned above, the basic ATR parameter is the 14 period, while for the standard deviation indicator, traders usually set the 20 period.

The key differences between the ATR and standard deviation are:

• Standard deviation increases the weight of larger values over smaller values. The ATR indicator is based on the average of absolute changes.
• If we apply the indicators on a daily chart, ATR considers intraday and between-day data, while the standard deviation calculation includes only daily returns.

How Does the Average True Range Indicator Work?

The Average True Range indicator is simple and can be used even by beginners. It consists of one line that moves within a range. You should remember that the indicator never shows the trend direction. When the indicator rises, it’s a sign that the price is becoming highly volatile. If it goes down, volatility is low.

When the indicator moves low for a period of time, it means the market is quite calm. The price may move sideways in such periods. A sideways movement reflects a price correction. Thus, traders may expect an upcoming formation of a new trend or a continuation of the old one.

If the indicator rises significantly, it’s a signal the price suffers large price fluctuations. Usually, increased volatility doesn’t last for a long time. It means that the price will either correct soon or change its direction.

How To Use the Average True Range

Traders and analysts widely use ATR to define entry and exit points. Although the indicator can’t define the price direction, it can show you the periods when the market is calm enough or going to calm down. This will help you enter or exit the market without slippage, as it’s unlikely there will be a price gap.

You shouldn’t use the ATR tool alone. Combine its signals with indicators and chart patterns that reflect the price direction or the momentum, like, for example, RSI or Stochastic oscillators.

ATR Breakout

A breakout is a market condition when an asset’s price breaks above a resistance line or below a support line. A breakout signals a potential formation of a trend in the direction of the breakout. Breakouts are accompanied by increased volatility, as bulls/bears need to be strong enough to push the price above/below strong rebound levels.

To catch a potential breakout, find a period when the ATR indicator is low or flat. It may signal a prolonged price consolidation. If the price corrects for a certain period and moves sideways on the price chart, while the ATR indicator is either low or flat, wait for ATR to surge and enter the market in the direction of the breakout. This approach will allow you to enter the trend at the very beginning of its formation.

Trend Filter

The indicator can also be applied to determine the strength of the trend and its possible change. To use ATR as a trend filter, you need to either estimate the middle point of the indicator movement by eye or add a moving average on the indicator (not on the price chart). The period of MA will depend on the timeframe you trade on. For big timeframes, it’s recommended to use such periods as 100 and 200; for lower periods, apply MAs with 9 or 12 periods.

As you already know, low indicator readings signal a weak trend, while a rise in the indicator reflects increased volatility. You also already know that the increased volatility can’t last for a long period. This means that a trader can expect a change in the trend.

We may use the middle line to define whether the trend is weak or if there may be a return soon. When ATR falls below the middle line/moving average, the market becomes calm. A rise above the line may signal a formation of a new trend and its upcoming change.

Stop-Loss Orders

Average True Range can be applied to define stop-loss levels. Although it won’t define certain levels, it will help you measure how far the order should be placed. In periods of high volatility, you should place broad stop-loss levels. Otherwise, there are high risks that you will be taken off the market fast. On the contrary, trades in periods of low volatility should be marked with narrow stop-loss orders. Otherwise, you may lose the possible profit.

Trailing Stops

ATR is also used for trailing stops. Trailing stops allow traders to exit the market with minimal losses. In a successful trade, they move according to the price, narrowing the distance between the current price and stop loss. When the market turns around, a trailing stop allows traders to save what they have earned.

To determine the trailing stop level, you should check the current ATR value. The idea is that you multiply the ATR value twice and place the stop-loss level at a distance equal to doubled ATR from the entry point. For example, if you trade in an uptrend, you should place a stop loss at a distance twice the ATR below the entry point. If your trade is successful, you should move the stop-loss level accordingly so that the distance between the current price and the stop loss always equals the doubled ATR value. It means that the stop-loss level will never go down. It will follow the price within the bullish trend.

If you trade in a downtrend, you should place a stop-loss order at the level equal to the doubled ATR value above the entry price. Trail the stop-loss level the same way you would do for a buy trade.

Average True Range Strategies

We have told you how the ATR indicator works and what signals it may provide. Using this knowledge, you can already try to open and close trades on a demo account or even develop your own trading strategy. However, if you are a beginner, it’s recommended to use proven strategies.

ATR Day Trading

You can apply ATR on short-term charts, including 1-, 5-, 15-, and 30-minutes. The indicator signals increased volatility when the market opens. After, it mostly moves downwards. This doesn’t provide lots of useful information. The only thing you can learn is the average price movement within a minute. Using this information, a day trader can define how much time the price needs to reach a certain level.

To calculate the approximate time the price will need to reach the profit target, you need to divide your expected profit by the ATR value.

For example, if you need to know how much time it will take for the asset you trade to move by three cents, you need to divide three by the ATR value (let’s imagine it’s 0.03). Then, you will know that on the 1-minute chart, the price may move by 3 cents within 1 minute.

ATR Buy Sign

Although the indicator doesn’t show the price direction, it can help to define entry points. If an asset moves within an uptrend, you should add the value of one ATR to the latest closing price. If the price is above this level, you can enter the market. In case of a downward movement, you should also add the value of one ATR to the latest closing price. If the price trades below this level, you can open a sell trade.

Such signals should always be confirmed by other indicators or chart patterns. As the major function of the ATR indicator is the measure of the price volatility, its buy and sell signals should be taken cautiously.

Exit Signs

This strategy does not guarantee 100% accuracy. However, you can test it. Use a NAGA demo account to practice various technical indicators and trading strategies.

Traders should exit a buy trade if the price closes more than one ATR value below the latest closing price. In case of a sell trade, traders are recommended to exit the market if the price closes more than the value of one ATR above the latest close. It may be a sign of a trend change.

What Are The Advantages of Using The Average True Range?

The Average True Range indicator has many advantages. Therefore, it’s widely used by traders. You may have defined its pros yourselves. However, we will list the key benefits.

• It reflects the strength of price volatility
• Short-term trades are safer when applying a volatility indicator with absolute levels
• ATR also works for longer-term investing
• The indicator reflects a trend change
• ATR is used to determine a price correction
• It can be used to set stop-loss levels and lock profits
• The indicator can be applied on a price chart of any financial instrument, including commodity, indices, crypto, and forex.

What Are the Limitations of Using the Average True Range?

As any indicator has its own drawbacks, we should mention the ones of the ATR indicator. We would highlight two key pitfalls you should always remember when trading using the ATR indicator.

• It may be difficult to interpret ATR signals, as there is no single value that would mean increased or decreased volatility. The indicator may be read in many ways. That’s why trading strategies based on this tool are not reliable. You should always compare current ATR readings against the previous ones to determine the trend’s strength.
• Remember that the indicator doesn’t show the price direction. It reflects the strength of volatility but never shows where the market moves.

Final Thoughts on the ATR Indicator

The Average True Range indicator is an important technical tool that measures market volatility. It’s a well-known fact that volatility is dangerous even for experienced traders. Thus, any trader should be equipped with various tools that help to deal with it.

Although ATR doesn’t reflect the market direction, it may help to filter trends, trade in periods of breakouts, and set stop-loss orders.