The Average True Range (ATR) indicator was developed and proposed as a technical indicator by Welles Wilder. It does not determine the direction of the trend in the market but acts solely as a measure of its volatility. Initially, its use was assumed in commodity markets, which are characterized by price gaps (gaps) and price limits (the limit of maximum price movement during a trading session established by the futures exchange). However, later the ATR indicator was widely used to analyze others, in particular the forex market.
What is the ATR indicator?
The author of the theoretical basis for calculating this technical indicator and its application was Wells Wilder, the developer of the popular ADX indicator. The purpose of the average true range is associated with the study of such a characteristic of processes occurring in the market as volatility.
This is a kind of market temperature. Low volatility indicates a sleepy state of the market, which can change dramatically at one point, and prices may start to jump up and down for a short period. Market volatility in the latter case will be significant. This market parameter is closely related to the risks arising from trading. The trader must calculate their risks in advance, especially as a result of unfavorable development of the market situation for them. Ideally, entering the market, the trader should know the final conditions for exit from the market and have a suitable stop loss in place.
Important ATR indicator features
The ATR indicator can be a good assistant for any trader in determining the temperature of the market. To calculate the indicator, data are used on the moving average, as well as the maximum and minimum prices for the study period. Based on the calculation methodology, it characterizes the magnitude of price fluctuations. It allows you to determine the average price range over a set period, which can be used to help identify range bound and trending markets.
Another essential feature of ATR, determined by the methodology for calculating it, is that absolute rather than relative values of the price are used, so the average true range for different trading instruments can differ significantly from each other.
How to trade with the ATR indicator?
The figure shows a graphic image of the indicator of the average true range superimposed on the price change chart. The jump in the ATR value corresponds to the price area with significant price drops in a short interval.
An essential condition for the accuracy of the signals from the indicator of the average true range is the averaging period selected for calculation. As a rule, it is set equal to 14 days.
A smaller value of the period makes this indicator overly sensitive, including regular market noise, which is expressed on the chart by fluctuations of lower amplitude. The increase in the averaging period considerably smoothes the ATR curve on the graph, making it not entirely apparent and suitable for visual analysis. But this is not a dogma. The main thing in working with this indicator is experience, which will tell you all the parameters of its possible settings that suit your individual trading strategy and goals.
The fact that the ATR indicator is an auxiliary technical indicator affected its popularity and frequency of use in exchange trading.
ATR trading strategy
This trading system is used on the major EURUSD pair due to its liquidity. However, you can try experimenting with other pairs. I find it better to use for trading on the hourly charts and above as there can be less “noise” compared to lower timeframe charts. The purpose if this ATR strategy is to try and catch a trending move at the early stages.
To open buy positions, it is essential to evaluate the values of the ATR indicator. If it is below the level of 0.0019, then we can open a buy position. Also, take confirmation from 20 SMA.
To open a sell position, the price must touch the upper MA level, we also evaluate the values of the ATR indicator, if they are below the level of 0.0019, then we open sell positions.
I would look to place stop loss around previous support/resistance levels and exit either on an opposite signal or when my take profit target is reached. The trade could also be locked in at a breakeven point with a trailing stop to try and maximise the move. I would only take trades which give a favourable risk to reward ratio of at least 1:2, ideally more. This is so that one losing trade does not wipe out multiple winners
ATR indicator conclusion
ATR is a classic indicator by Welles Wilder. Unlike other indicators, this indicator helps to determine the volatility of the market. We can use 20 SMA with ATR to confirm the trend and enter the trade. However, the system may produce false signals. Therefore, due diligence is required to backtest and filter the false signals.
The methods of implementing the ATR indicator into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice trading with the ATR indicator, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.