The ATR is a very popular trading indicator but I see often that many traders interpret or use the ATR incorrectly. With this guide I want to help create more clarity around this useful indicator and show you how it can help your trading.
Calculating the ATR
I won’t bother you with math formulas but I want to show you how the ATR is being calculated based on some simple candle examples. I strongly believe that a trader MUST understand how his indicators are being created to make the right trading decisions. It’s pretty easy, though, as you will see.
ATR stands for Average True Range which means that the ATR measures how much price moves on average. Below there are three examples of what the ATR does use for its calculations.
During a move up, it measures the distance between the previous close and the current high of a candle (left).
During a move lower, the ATR looks at the previous close and the next candle’s low (middle).
When the distance between the previous close and the current low/high is very small, the ATR would look at the complete range of the candle and take the high and low (right).
This is a very simplistic way of looking at the ATR and there is a little more to it from a mathematical point of view, but it provides a good starting point for our further explorations.
Momentum vs Volatility
The ATR indicator measures volatility. Traders often mistakenly believe that volatility equals bullishness or bearishness. Volatility does not say anything about the trend strength or the trend direction, but it tells you how much price fluctuates. As we have seen above, the ATR just looks at how far price swings and not how much it actually moves into one direction.
Volatility = How much price fluctuates around the average price. In a high volatility environment, price candles usually have long wicks, you can see a mix of bearish and bullish candles, and their candle body is relatively small compared to the wicks.
Momentum = Momentum is the exact opposite. Momentum describes the trend strength into one direction. In a high momentum environment, you typically see only one color of candles (very few candles moving against the trend) and small candle wicks.
The screenshot below shows the differences. The ATR measures volatility, while the RSI measures momentum:
Scenario (1) shows a high volatility and medium momentum phase; lots of candle wicks and back and forth, but price is only going down slowly >> High ATR and low/middle RSI
At point (2), you mostly see white candles, almost no candle wicks; this is a low volatility and medium momentum phase >> Low ATR and high RSI
At point (3), you can almost only see red candles and very few candle wicks; this is a low volatility and high momentum phase >> Low ATR and very low RSI
Combining the ATR with the RSI can tell you so much about the market you are in. Being able to understand which type of market you are looking at, can help you make much better trading decisions.
Volatility in uptrends and downtrends
Understanding volatility is important to make the right trading decisions as we will see later. Understanding how volatility changes with market context can help you make much better trading decisions as well.
The screenshot below illustrates how volatility changes significantly during different market periods. Whereas volatility is low and decreasing during uptrends (when price is above the moving average), volatility rises significantly when prices are falling and are below the moving average.
This market behavior is also observable in the stock market and the screenshot below shows the DAX. Again, volatility picks up significantly once price entered a downtrend and dipped through the moving average. During the uptrends, there is significantly less volatility. A change in volatility and a price break below/above the moving average can, therefore, be great indications of a new trend. Often, a change in volatility can even foreshadow a trend change and signal the origin of new trends.
ATR + DATR
Now it is obvious why it pays to know the overall market direction and the higher time-frame status. Most traders trade on the lower timeframes and quickly forget what they have seen on the higher time-frame after having done their multiple time-frame analysis. The DATR is the Daily Average True Range Indicator and it only measures the volatility on the daily time-frame.
The screenshot below shows that the DATR went down all the way while the ATR on the lower time-frame moved in waves. However, all lower time-frame ATR volatility-spikes were very short-lived. This shows that knowing the overall higher time-frame situation is critical to understand what to expect on the lower time-frames. A low DATR typically leads to lower volatility on the shorter time-frames and volatility spikes aren’t sustainable.
How to use the ATR
The ATR not only provides information about the current market state, but it is also a tool that can be used to make trading decisions. Especially when it comes to stop loss, take profit and trade exit improvements, the ATR can be of great help.
SL – Volatility Stop
The most common use for the ATR indicator is to use it as a stop loss tool. Basically, when the ATR is high, a trader expects wider price movements and, thus, he would set his stop loss order further away to avoid getting stopped out prematurely. On the other hand, we would use a smaller stop loss when volatility is low.
The screenshot below shows a chart with the volatility stop indicator – the green dots below and above price. The volatility stop is an equivalent to the ATR stop loss strategy. The volatility stop adjusts your stop placement based on price volatility. It keeps you in trades during trending phases and gets you out of trades during larger retracements. In a range-environment, the volatility stop does not work as well.
Adding a moving average to the volatility stop is an additional way to make sense of your price data. The volatility stop keeps you in as long as the moving average hasn’t been broken significantly.
Trade potential and profit potential
The ATR also helps you understand the profit potential of your trades. Whereas you should aim for a closer take profit in a low volatility environment, setting your take profit order further away when volatility is high, can improve your trading.
As we have seen, in a high volatility market the volatility stop would lead to a larger stop loss distance. To offset a wider stop loss, the ATR will also tell you to aim for a larger take profit when volatility is high. Thus, a trader does not reduce his reward-risk ratio by only adjusting his stop loss.
The ATR indicator as your universal market tool
The ATR is a great tool when it comes to adjusting and adapting to changing market conditions. But it can also be a great indicator to anticipate market turns once a significant change in volatility is observable.
Most traders experience inconsistent results which is often the result of an inflexible trading approach. The volatility stop and the adjusted take profit placement can help you overcome those problems. Together with the volatility behavior of the higher time-frames and the differences between uptrends and downtrends, the ATR makes for a universal trading tool.
image credit: www.tradingview.com