Forex ATR Indicator - What Is It and How To Use
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The ATR ('Average True Range') indicator measures market volatility and is one of the most popular and universal technical indicators used by traders today. In this article, we will explain the logic behind it, how it is calculated and how you can utilize the ATR indicator in your trading strategy.
What is the ATR Indicator?
Developed by J. Welles Wilder, and published in his book 'New Concepts in Technical Trading Systems', ATR is a type of volatility oscillator, meaning that it is applied to a price chart and visually displays results below in the form of a line. It is typically smoothed over 14 periods (the number of historical price bars) and indicates on average how much an asset price moves during a given time period.
Originally developed for commodities trading, the ATR is now widely used in other markets, such as forex ATR. The indicator does not indicate a trend direction, rather it simply analyses the amount of volatility in the market.
How does the ATR work?
The ATR indicator works by first determining the True Range (TR) for the current bar and several previous ones (usually 13) and then averaging the data to indicate how much on average a particular instrument will move.
The 'True Range' value of a bar/candle is first defined as the largest absolute value of:
- Current high price minus the current low price
- Absolute Value of current high minus previous close
- Absolute Value of current low minus previous close
The last two are used in cases where the previous closing price was outside the current range, ie the previous day, to account for gaps particularly in stock and future assets. The highest absolute value is taken, regardless of whether it is positive or negative.
A moving average is then applied to the series of 'True Ranges' to smooth out the data and represent it more profoundly. This is used to determine periods of rapid price movement where most action occurs in the market.
How to read ATR indicator?
In a nutshell, the higher the ATR value, the more volatility there is on that instrument at that time, whereas a lower ATR value indicates less volatility.
A new result is calculated for each new period, so for example on a 1H chart, it would update every one hour on a 1M chart it will update every one minute and so on.
The indicator will typically spike up at the market opening, as there is more volatility at the start of a trading session. On stocks for example you will see a spike when the exchange opens daily, which is simply indicating the daily atr volatility is higher than what it was at the close.
It is important to also consider the historical ATR readings to get an overall picture of movements in price action.
How to calculate the ATR
The calculation of the ATR requires historical price data only and is relatively simple compared to some other indicators.
Suppose you want to analyze the volatility of Gold over 10 days. You can begin to calculate this by taking the value of the current high minus current low, value of the current high minus the previous close or the value of the current low minus the previous close (whichever is highest). You would repeat this to find the true range for 10 daily candles, and once smoothly averaged, will provide the first 10-day ATR reading.
The ATR formula
The full formula of the Average True Range is as follows; however, this is not something you need to calculate manually yourself, thanks to the ATR indicator which is pre-installed on all of the trading platforms offered by FxPro.
TR=Max[(High - Low),Abs(High – Close Previous),Abs(Low – Close Previous)]
TR= particular true range
n= specific time period
How to use the ATR Indicator in Trading
The ATR is particularly optimized for Futures & Commodities, however, it can also be applied to forex and other securities.
The recommended period setting is 14. If traders use a higher period, there will generally be less trading signals generated, whereas a shorter period will increase the number of signals.
In terms of trade entry, ATR can be used to confirm signals given by other indicators or give warning signs for when it might not be a good time to enter the market. For example, if an asset has already changed by more than the average, it may not be ideal to enter a trade and expect an even bigger movement.
Besides gauging the strength of a trend and confirming entry signals, ATR is most useful for determining the trade size and stop-loss distance, as well as ideal take-profit.
ATR can help to determine to trade size by indicating how much a particular asset moves, so you don't take an unnecessarily large position on an instrument that is very volatile. In general, the higher the ATR, the smaller the position and vice versa.
A common mistake of novice traders is setting a stop loss too tight, so using ATR can help you set a stop loss at a level to account for daily market swings. If the ATR is high, you can expect wider movements and therefore set the SL at a wider distance to avoid being stopped out prematurely, whereas a low ATR suggests not much of a price range and you may therefore set the SL at a tighter level. The same logic applies to take profit levels.
Another common application is the chandelier exit strategy, whereby a trailing stop is placed below the highest high since the position has been opened. The distance between the stop level and the highest high is determined based on some multiple of ATR. So, for example, a trader may subtract 2X the ATR value from the highest high.
You could also use the same process as above to set Stop Loss at a particular distance from the support or resistance levels.
When deciding on a multiple to use, there is no right or wrong answer, it depends on your trading, but of course a smaller multiple will mean smaller trends and a shorter trade, whereas using a bigger multiple allows you to catch the bigger trends and hold the trade for longer. (provided it goes it your direction).
What limitations does the ATR have?
The ATR is only measuring volatility and does not give clear signals or indication of price trend/direction. Therefore, is it very subjective and should be used in conjunction with previous price trends and other data. You should also be on the lookout for misleading signals, for example, an increase in ATR values may be indicating a trend reversal, rather than a continuation or strengthening of the current trend. On the other hand, a trend may be continuing whilst volatility is low.
As we explained, atr is used to measure volatility, so it has limited use in markets that are not liquid or subject to price swings. For example, FX pairs in which the exchange rate is controlled.
Experts suggest combining the ATR with the use of a momentum, or trend indicator, such as the RSI (relative strength index) to help with your trading decisions.
Using the ATR Indicator in MT4 & other FxPro Platforms
The ATR Indicator is included in the MT4, MT5 & cTrader platforms as standard and has a period setting of 14 as default, however, this is easily adjustable in the indicator preferences.
The indicator will appear as an oscillator on your trading chart, plotting the peaks and troughs of volatility over time, and if you hover your mouse over the line it will display the exact ATR at that moment.
Opening a FxPro forex demo account on Metatrader 4 or any of our other platforms is a great way practice using the indicator and get to grips with it.
Using the ATR value Indicator
Another variation of ATR that is popular is called ATR value indicator and is available as a custom MT4 indicator. The ATR value indicator is a simpler version which displays the MT4 ATR value in pips/points on the chart itself and has an option to set a multiplier.
This makes it a little easier to use to determine take-profit levels, as the MT4 ATR value is shown in the top right corner of the chart. You are also able to edit the 'period', 'multiplier' and 'unit' settings that the ATR value indicator will display.
Another advantage of the MT4 ATR value indicator over the original MT4 ATR indicator is it will not clutter your trading chart by taking up space.
An equivalent custom indicator in cTrader is called 'Average True Range Pips'.
ATR Indicator in Summary
- The Average True Range indicator is one of the most popular and widely used by traders to measure market volatility.
- It does not help to indicate price direction.
- Can be used to confirm trade entries.
- Is especially useful as an exit strategy, to determine SL/TP levels or position size.
Hopefully, you now have a better idea of the way the indicator works and how it can be utilized in CFD trading.