ATR Indicator: The Average True Range

August 24, 2021 15:10 UTC
Reading time: 9 minutes

It is not that difficult to look at a chart and be able to spot periods that are more volatile than others — that is, where stretches occur when the market is more active and price movements occur more rapidly. But what do we do when we want a more qualitative approach to gauging market volatility? 

In this article, we are going explain what the ATR indicator is, what it measures and how to use it with MetaTrader 4 (MT4) and MetaTrader 5 (MT5). We will also take a look at how the average true range indicator can be used as part of a trading system. 

When trying to assign a numerical measure to volatility, the most direct value to look at is the range of the market — which is how much the market moves within a given time. The most obvious way to measure range is to look at the difference between the highest price and the lowest price in one time frame.

Simple, right?

Well, not always. One of the best-known technical analysts to first write at length about using volatility as an indicator was J. Welles Wilder. In his 1978 book 'New Concepts in Technical Trading', he introduced many cornerstones of modern technical analysis, including the Relative Strength Index (RSI), the Average Directional Index (ADX) and the Parabolic SAR Indicator (PSAR). Among this deluge of influential technical indicators was one designed expressly for the purposes of measuring volatility — the Average True Range Indicator (or ATR indicator).

What Is the ATR Indicator?

J. Welles Wilder developed his indicators while looking at the commodity markets. He realised that solely looking at the day's range was too simplistic as a measure of volatility. This is because of the way in which commodities frequently go limit up or limit down — or gap in price from the previous day's close to the new opening.

This meant that to adequately reflect the true volatility of the market, he needed to consider the previous day's close as well as the current high and low. Proceeding from this realisation, he defined the true range as being the greatest out of the three following values:

  1. The distance between the current high and the current low
  2. The distance between the previous close and the current high
  3. The distance between the previous close and the current low

Wilder then proposed taking an average of this value over several days in order to provide a meaningful representation of volatility. Logically enough, he called this the Average True Range.

The Average True Range Calculation

The average true range for the current period is calculated as follows over 'N' periods:

  • ATR = Previous ATR (n-1) + True Range of current period

As the equation requires a previous value of the ATR, we need to perform a different calculation to obtain an initial value of the average true range. This is because for the initial ATR we will, by definition, have no previous value to use. For the initial ATR, therefore, we simply take the mean average of the true range over the prior 'N' periods.

So what value should you use for 'N'?

If you average over a greater number of days, you obtain a slower volatility indicator. If you use a smaller number of days, you will have a fast volatility measure. Wilder recommended using 7 or 14 days for optimal performance, depending on which trading system one was using.

Fortunately, traders who use either MetaTrader 4 or MetaTrader 5 will not need to worry too much about the average true range calculation, as both trading platforms will perform the calculation for you instantaneously.

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The ATR Indicator in MT4 and MT5 

The ATR indicator comes with the standard package of indicators available when you install both MT4 and MT5. 

In both MetaTrader 4 and MetaTrader 5, you will find the average true range indicator listed in the 'Indicators' section the 'Navigator' window on the left-hand side of the screen.

When you add the ATR indicator to your price chart, the only variable you need to think about is the ATR Period, which we briefly mentioned above.

This is the number of periods over which MetaTrader will calculate the average true range. As shown in the screenshot below, the default value is 14, which is an excellent choice for traders who are unfamiliar with the ATR indicator to begin with.

Source: Admirals MetaTrader 5 - The Average True Range Indicator Settings

Once you click 'OK', a graph displaying the average true range indicator will appear beneath your main price chart. This is shown below in an hourly GBP/USD chart, with a 14-hour ATR indicator applied:

Depicted: Admirals MetaTrader 5 - GBPUSD H1 Chart. Date Range: 16 August 2021 - 24 August 2021. Date Captured: 24 August 2021. Past performance is not a reliable indicator of future results.

The peaks on the ATR indicator chart above show more volatile trading times; the troughs indicate less volatile periods. Hovering your cursor on the line chart will provide you with the exact value of the average true range at that particular point in time.

How to Use the ATR Indicator in Trading

Wilder originally proposed an ATR trading strategy that was a core part of his trend-following volatility system. The rules assume you have entered a trade following the trend — for example, buying into a market making new highs each day.

The rules of this ATR trading strategy are reasonably simple to follow, and effectively dictate where to stop and reverse your position. Here are the steps involved:

  • Multiply the average true range by a constant. Wilder recommended 3.0 as the constant and called the resulting value the ARC
  • Find the significant close (SIC). This is the extreme favourable close in the preceding 'N' days
  • Square and reverse your position one ARC from the SIC

This was designed to be used with daily values and for these rules, 'N' was set at 7, to give a sufficiently fast reaction to volatility.

In a broad sense, you can use the ATR indicator as a guide to the appetite in the market for pursuing price moves. For example, if a market moves higher, it is only if a strong appetite remains for further buying that the range will continue to extend. Should ranges narrow, some may interpret that as suggestive of declining interest in terms of pursuing the net directional movement.

Other Uses of the Average True Range in Trading

Because it gauges market volatility, you can also use the ATR indicator as a tool for guiding stop and limit placement and also for position sizing.

These uses for the average true range indicator are probably more prevalent these days than as a generator of trading signals.

The famous Turtles — a group of novices who achieved great trading success in the eighties after just a few weeks training — used the ATR indicator for position sizing. They did this to normalise the dollar volatility of their positions. Their trading rules called for them to trade on any one of more than twenty different contracts, based on price movement.

As they did not know which positions would win or lose, they needed to adjust for the volatility of the different markets. This prevented, for example, taking a large loss just because that contract happened to move more than the others. They specifically used a 20-day average true range. The higher the value, the smaller the position they took and vice versa.

Summary of the ATR Indicator

The ATR indicator was originally designed with commodities in mind, but today it is widely applied to both the stock and Forex market.

The 'Turtles' mentioned above, for example, traded a cross-section of bond, commodity, and Forex futures, and used the ATR indicator as their position-sizing tool for all. Average true range Forex sizing works just as well as average true range commodity sizing, because volatility is a universal market concept.

As the ATR indicator does not measure direction and simply considers the magnitude of range, it has limited use as a means for generating trading signals.

However, it is a useful tool for providing an idea about how much a market may move. This, in turn, informs key trading decisions such as position size and stop placement.

Trade on a Risk-Free Demo Account

To find out how the average true range can help with your trading, why not experiment using the ATR indicator on a risk-free demo trading account! A demo trading account allows you to practice trading in real-market conditions using virtual currency, before risking your own capital on the live markets.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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