The Average True Range (ATR) indicator is a simple tool but is very useful in measuring volatility. It is another indicator that was developed by J Welles Wilder and can be used on any market successfully.
Simply put, the ATR measures the price range of a stock or security so that the higher the volatility of a security the higher the ATR.
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The ATR is measured as the greatest of any of the following 3 metrics:
- The current high minus the low
- The value of the current high minus the previous close
- The value of the current low minus the previous close
Whichever is the highest of these three metrics is then represented as the average true range of the security. Typically, the number is then smoothed using a 14 day moving average.
Finding the average range of a security has a number of important implications that can help make better trading decisions.
Using the ATR outright to trade volatility
First of all, the ATR can be used as a trading signal in its own right. Let’s say that you are watching a market for a number of days and you have noticed that volatility has dropped significantly from its historical average. Since low periods of volatility often precede explosive moves in either direction, you could wait for the ATR to increase and place a trade in the direction of the move. Crossovers can also be used. For example, placing a trade when the fast ATR (eg. 14 period) crosses over a slower ATR (eg. 100 period). This can be an effective breakout volatility strategy.
Using the ATR for profit targets
For day traders, knowing the average range of a security is extremely useful since it allows you to estimate how much profit potential there is in the market.
For example, there is no point looking for 150 pips of profit from a trade in GBPUSD, if the average range for that market over the last 14 days is only 80 pips. You will simply end up waiting for profits that do not come and will likely end up losing money.
A better solution is to halve the 14 day ATR and use this as your profit target. In other words, after entering a trade in GBPUSD as above you can give yourself a profit target of around 40 pips. This is a much safer way to trade.
Using the ATR as a filter
The average range is also a good indicator to use for filtering out trades. Traders typically need volatility to make any money so if you have a system that generates lots of different signals, you can filter out those ones that are low in volatility by discarding those with a low ATR. Concentrating on markets with the highest ATR’s mean you can trade the markets that are experiencing the most movement and therefore the most profit potential.Get the 5 most predictable currency pairs