ATR Indicator Basics: Concept, Calculation, Applications, and Plotting Methods
In the technical analysis of FX, stocks, and other financial markets, the Average True Range (ATR) indicator plays a critical role. ATR is mainly used to measure market volatility, providing traders with significant insights into the amplitude of price fluctuation, which therefore reminds them to consider potential risks and market fluctuations while establishing trading strategies. By quantifying market volatility, ATR helps traders ATR allow traders to set the levels of stop-loss and take-profit more accurately and manage the timing and risk of trading better.
This will introduce the functions and calculation methods in detail and discuss how to use this indicator to optimize trading strategies.
What is ATR?
The Average True Range (ATR) indicator was introduced by Welles Wilder, a renowned technical analyst, in 1978 to measure market volatility. Originally designed for the commodities market, this technical indicator is now widely used across various markets, such as forex, stocks, and futures.
ATR provides quantified data measuring the amplitude of market fluctuations by calculating the average daily price movement over a specified period. This data is particularly valuable to traders as it helps them understand the level of uncertainty and risk in the market. Unlike other indicators, ATR does not directly indicate the direction of a price trend; instead, it reflects the magnitude of price changes, enabling traders to adapt their strategies according to market volatility.
ATR Calculation Method
The calculation of the ATR indicator involves several steps, with the primary goal of determining the average true range over a specified period. The true range (TR) represents the largest price range within a trading day and is calculated as follows:
| Calculation Item | Description |
|---|---|
| Calculate the price range for the day | The difference between the day's highest price and lowest price. |
| Compare the previous day's closing price with the current day's high | The difference between the previous closing price and the current day's high. |
| Compare the previous day's closing price with the current day's low | The difference between the previous closing price and the current day's low. |
The term “True Range (TR)” refers to the largest value among the above three. TR = max[(High – Low), |High – Previous Close|, |Low – Previous Close|]
Once the daily TR values are obtained, ATR can be calculated by averaging them. ATR is generally calculated using moving averages in a 14-day period, and the length of the period can be adjusted according to the needs of the trader. If the simple moving average is used, the equation for ATR calculation will be as follows.
ATR = (TR1 + TR2 + … + TR14) ÷ 14
However, to obtain a smoother indicator in the actual use, Welles Wilder suggested calculating ATR with an exponential moving average (EMA).
Basics of Moving Averages (MA): Concepts, Types, and Actual Uses
When calculating the True Range (TR), the use of absolute values in the formula ensures that TR is always non-negative, reflecting the magnitude of price fluctuations regardless of upward or downward movements.
Since the Average True Range (ATR) is the EMA of these non-negative TR values, the ATR value is also inherently positive. This design enables the ATR to reliably measure market volatility, regardless of market trend directions.
Applications of the ATR Indicator
The ATR indicator primarily measures market volatility rather than determining its direction. Therefore, ATR is often combined with other technical indicators for comprehensive market analysis. Below is how ATR relates to market trend momentum:
Rising Trend with Increasing ATR:
When the market shows an upward trend and the ATR value increases simultaneously, this often indicates that the upward trend's momentum is strengthening, with more active buying activity.
Rising Trend with Decreasing ATR:
If the market is in an upward trend but the ATR value decreases, it may suggest that although the trend remains upward, the momentum is weakening, and volatility is reducing.
Falling Trend with Increasing ATR:
In a downward-trending market, an increasing ATR value suggests that the downward trend's momentum is intensifying, with growing selling pressure.
Falling Trend with Decreasing ATR:
When the market is declining and the ATR value decreases, it suggests that although the market continues to fall, the downward trend's momentum may be weakening, and selling pressure is easing.
⚠️ Note: ATR is a non-directional indicator. Changes in its values should not be used directly to determine the market trend's direction. When using ATR, combine it with other indicators and market analysis tools to ensure more accurate market judgments and trading decisions.
Applications of the ATR Indicator in Trading
ATR is a strong tool to measure market volatility, it is mainly used for risk management and optimization of trading decisions. Examples of applying ATR in trading are as follows.
1. Setting Stop-Loss Levels
ATR can help traders set more effective stop-loss levels. Generally, traders adjust the spacing of stop-loss levels according to ATR to prevent the stop-loss from being triggered by normal fluctuation of the market. For example, if ATR is 50 points, a trader might place a stop-loss level which locates 50 points or more from the current price to prevent unplanned exit due to short-term price fluctuations.
2. Adjusting Position Sizes
ATR can also be used to adjust the sizes of positions to manage potential risks. In highly volatile markets, traders may reduce position sizes to reduce risk, and vice versa. By determining market volatility through ATR, traders can manage their funds in a more flexible manner and optimize the balance of potential risk and reward.
3. Identifying Entry Points
Although ATR itself does not indicate price direction, it can be combined with other indicators (e.g., trend or momentum indicators) to identify potential entry points. For example, if the trend of the market is significant and ATR is rising, it indicates the possibility of a strengthening trend, which can be taken as a signal of entry.
4. Determining Price Targets
ATR can also facilitate the setting of price goals. Traders can use ATR to measure the possible movements and therefore set realistic profit targets. For example, if a buy signal appears and the ATR for the day is 100 points, the trader may possibly set a price target around 100 points higher.
5. Predicting Market Reversals
For some strategies, ATR changes can be to predict possible market reversals. If ATR suddenly decreases after a highly volatile market condition, it might suggest weakening market momentum and an impending market reversal.
How to Plot the ATR Indicator on MT4
1.Log in to MT4.
2.Open the chart of the trading instrument.
3.Select Insert > Indicators > Oscillators > Average True Range from the menu bar; alternatively, navigate through Navigator > Indicators > Oscillators > Average True Range.
How to Add the ATR Indicator in MT5
1.Log in to MT5.
2.Open the chart of the trading instrument.
3.Select Insert > Indicators > Oscillators > Average True Range from the menu bar; alternatively, navigate through Navigator > Indicators > Oscillators > Average True Range.
