This is one of the most efficient volatility indicators and it is being used by virtually every trader in the world. The ATR is a volatility indicator that does NOT show the price’s trend; instead it illustrates the strength of the fluctuations. Why is this helpful? Well, you already have multiple indicators for the price’s trend, strength, reversals and so on, but you could use the help of an indicator that tells you what profit or loss you can expect. The ATR is most useful in a daily chart, but if you have a different strategy, you can use it in other time frames.
The ATR was introduced by J. Welles Wilder in 1978 and it calculated the “True Range” of the price, but this technique was not efficient enough, so he improved it by using the SMA 14 to smoothen the ATR. The formula today looks like this: ATR = SMA (TR) 14 There are three variants of the TR formula, they are all valid, but the difference comes if the market has opened with a gap or not.
The market is normal: TR = the highest price – lowest price.
The market has opened with an upward gap: TR = the highest price – previous close price.
The market has opened with a downward gap: TR = the previous close price – lowest price.
So, what does the ATR look like and how to read it? The ATR is a separate chart underneath the price chart and it looks like a Moving Average line. Reading the ATR is really simple – if the ATR goes down, then the market has decreased volatility and the bars in the price chart will be smaller; if the ATR goes up, then the market has increased volatility and the price chart will have bigger bars.
It is worth mentioning again that the ATR does NOT illustrate the trend’s direction, it does not provide sell or buy signal, but the indicator is priceless nonetheless. There are two methods you can apply when trading with ATR.
The first and most frequently used method is to use the ATR to properly determine your Stop orders. Generally speaking, if a market is too volatile, then you could afford wider Stop Losses, because you don’t want to be distracted by some secondary market noise and lose potential profits. On the other hand, if the market has low volatility now, then you should go for closer Stop Losses, because there is a bigger fluctuation coming and you can quickly lose massive amounts of money. There is one particular rule that we really like: always multiply the current ATR value by 2 and you will learn where to place your Stop Loss. To be more specific, here is an example. You are trading EUR/USD and you have enough signals to open a sell order. Take a look at the ATR and you will see that the current value is 0.0110 (for example). If you multiply this value by 2, you will get 220 pips – this is the maximum amount of pips that you should lose. Or in other words, place your Stop Loss 220 pips above the current price. Once again you would like to remind you that the ATR is most efficient in a daily chart, because it uses the data of the 14 previous days, by default.
The second method is to use the ATR to prevent some unexpected price movement and whipsaws (quick, unexpected change in the price’s direction). Once again, we will use a simple example to better illustrate our point of view. Let’s say you are trading EUR/USD (we really like this pair) and you have a signal for buy order, which should be placed as soon as the price breaches the level of 1.3500. Logically, when the price hits 1.3502, you will open an order. However it is quite possible to experience some unexpected price movement, maybe a slight correction or even a whipsaw; in either of these cases you will end up losing money, even though you have picked up the proper trend. So, what can you do? Always take a look at the ATR’s value; let’s say that in this particular moment (1.3502) it is 100. Always wait for 20% of the ATR, before placing an order. 20% of 100 = 20 pips so wait until the price hits 1.3520 and then place the order. This is very effective money and risk management technique that will save you a lot of money. You can use the ART filter when the price breaks a resistance or support level or any other indicator. Again, we recommend using the ATR on a daily chart for optimal results.Bollinger Bands
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