The average true range (ATR) indicator shows how much the price of an asset has been moving over a period of time. In other words, it shows how volatile the asset has been.
It helps traders predict how far the price of an asset may move in the future and is also useful when deciding how far away to place a stop loss or a profit target.
The ATR is a type of moving average of the asset's price movement, usually over a period of 14 days, but it can vary depending on your strategy.
The ATR appears on a chart as a moving average-type line
The ATR indicator is usually shown on a chart as a line. The image below shows how the ATR indicator typically appears on a chart:
The blue line in the chart represents the change in volatility of the price.
In the top left hand corner you can see the actual value – 0.0065 in this example. This is the range in pips that the price has moved over the given time frame. The above chart is a daily chart and so in this case, the volatility of the price is an average of 65 pips over the last 14 days.
Using this value, traders can expect the price movement on the given day to move by 65 pips.
The volatility of an asset can increase or decrease
When the line goes up, this means that the volatility of the asset in increasing. When the line goes down, this means that the volatility is decreasing. The ATR does not show you which direction the asset is moving.
The image below shows how the ATR shows high and low volatility:
- High volatility shown with higher ATR and larger daily range
- Low volatility shown with lower ATR and smaller daily range
Trading with the ATR indicator
Traders use the ATR to get an idea of how far an asset's price is expected to move on a daily basis. This information can be used to determine how far away a profit target/stop loss can be placed from the entry.
For example, if the ATR is showing a value of 100 pips and the trend that you are observing has exceeded 100 pips, then the trend has a higher probability of coming to an end.
The following chart shows how a trader can use the ATR to see how far the price is likely to move.
- At the time of the highlighted candle, the ATR is 125 pips, shown by the black line and the value on the right hand side of the indicator
- Long entry is initiated at the start of the day.
- The profit target is placed using the ATR value of 125 pips.
Using the ATR for the stop loss
You can also use the ATR to place your stop loss using the same principle. As the ATR gives you a good indication of how far the price will move, you can set your stop loss accordingly. By setting your stop loss away according to the daily range of the asset's price movement, you can effectively avoid market "noise" – temporary price movements up and down as the price moves in an overall direction.
Using the ATR value is optimal for placing a stop loss, because it allows you to place your stop loss the maximum distance away and avoid any market noise, whilst using the shortest stop loss possible to do so.
If the price then reaches your stop loss, then this means that the daily price range is increasing in the opposite direction to your trade and you want to cut your losses short as soon as possible.
Using the ATR value is then optimal for placing a stop loss, because it allows you to place your stop loss the maximum distance away and avoid any market noise, whilst using the shortest stop loss possible to do so.
Changing the ATR settings affects its sensitivity
The ATR indicator can be set to different time periods that affect how sensitive the indicator is.
The standard setting for the ATR is 14, which means that the indicator will measure the volatility of a price based on the 14 most recent periods of time. As mentioned above, this is typically 14 days.
Using an ATR setting lower than 14 makes the indicator more sensitive and produces a choppier moving average line. An ATR setting higher than 14 makes it less sensitive and produces a smoother reading.
Using a lower setting gives the ATR indicator a smaller number of samples to work with. This makes it much more sensitive to recent price action and will give a faster reading.
Using a lower setting gives the ATR indicator a smaller number of samples to work with. This makes it much more sensitive to recent price action and will give a faster reading.
The images below show how these two extremes appear differently on charts:
In the above example, the ATR has been set to 7 (top left corner of the indicator window), which is exactly half the standard 14 setting. This has resulted in the ATR line looking quite choppy.
In the image above, the ATR has been set to 28, resulting in a much smoother ATR line.
When changing the ATR settings, it is important to check whether your changes are actually improving or worsening your trading results.
To work out which setting best suits your personal trading strategy and style, place a series of trades using each of the settings you want to test out, log the results in your trading journal and then compare them to see which setting is most profitable for you.
Summary
In this lesson, you have learned ...
- ... the average true range indicator shows how volatile an asset's price has been over a specific period of time and helps traders predict future price volatility.
- … it is similar to the average daily range (ADR) indicator but can be applied to any time frame.
- … it is shown on charts as a moving average line.
- … it is usually used to place risk management orders - traders typically use bigger stop losses when a price's ATR is high and smaller stop losses when its ATR is low.
- … it does not work better with some market conditions than with other.
- … it will not provide information on price direction, entry points or whether a price is trending or trading sideways.
- … changing the ATR settings from the standard 14 periods will affect the indicator's sensitivity.
- … using a setting lower than 14 will make the indicator more sensitive, resulting in a choppier reading.
- … using a setting higher than 14 will make the indicator less sensitive, resulting in a smoother reading.
