The ATR is a popular trading indicator that can be used for many different trading scenarios. The ATR can be useful for trend-following, improving your understanding of the market, and even helping to optimize target positioning to enhance a trader’s rate.
This guide will explain the ATR indicator and then look at its various uses.
THE IDEA BENEATH THE ARTICLE
ATR is an indicator of volatility, which means it measures price changes. This is in stark contrast with other trend and momentum indicators, such as the RSIor STOCHASTIC. The ATR can be used to complement your price analysis and provide an alternative way of looking at the price movement.
I won’t bore you with formulas, but I believe that traders must know how indicators are created and why they go up or down to make the best trading decisions. As we’ll see, it’s actually quite simple.
ATR is an acronym for Average True Range, which means it measures the average price movement. ATR is a measure of candle size as well as the range of prices.
Below, I have set the ATR at one period, which means the ATR only measures the range/size/length of a candlestick.
This makes the relationship between candle size and ATR very obvious. The ATR increases the larger the candle. The ATR will be lower the smaller the candle.
The ATR measures the entire range of the candlestick, including the wick.
ATR is usually set at 14 periods, which means it looks at the range in candlestick sizes over the last fourteen candlesticks. The screenshot below displays the standard ATR of 14 periods. The periods highlighted show small candlesticks, which leads to a low or declining ATR. The ATR increases when the candlesticks grow in size.
This is, of course, a very simplified way to look at the ATR. Mathematically, the ATR is calculated in a slightly different manner. For the average trader, it is enough to know the relationship between the candle size (range) and the ATR.
MOMENTUM VS VOLATILITY
Traders mistakenly think that volatility is the same as trend momentum. Volatility does not tell you anything about trend strength or trend direction. Volatility is a measure of how much a price fluctuates.
Volatility is The amount the price fluctuates in relation to the average. Price candles in a high-volatility environment are typically larger and have longer wicks.
Motion = Movement describes the strength of a trend in one direction. In an environment with high momentum, candles are usually only one color (with very few candles moving in the opposite direction), and the candle wicks are smaller.
The screenshot below shows the difference between volatility and momentum using the STOCHASTIC Indicator. The ATR measures volatility, while the STOCHASTIC shows pure trend strength.
During the first phase highlighted, there was a strong bullish trend. The STOCHASTIC Indicator (lower window) was at a level above 80, which confirmed a strong trend. ATR had a low value due to the lack of large wicks and orderly trend behavior. This indicates a market with low volatility and high trending momentum.
The price was on a downward trend during the second highlighted phase. STOCHASTIC confirmed a strong bearish trend and dropped below the line of 20. The candlestick wicks this time were larger, and the movement wasn’t as ordered as it was in the previous bullish trends. This resulted in a higher ATR.
Interestingly, volatility can manifest differently in different markets. The screenshot below is the S&P500. A lower(er) ATR often marks uptrends. Downtrends, however, can be more extreme and show higher volatility.
The old saying, “Stocks use the elevator to go up and the stairs to go down,” comes from this.
These insights can be extremely valuable for traders in optimizing their decisions. When trading in high volatility, traders may need to take a different approach with regard to trade management and stop trailing. Changes in volatility can also be a sign of a shift in the market structure and trends.
TRENDS AND ATR
Market sentiment can be affected by changes in volatility.
A narrow range indicates a low-volatility market phase. The sideways scope is defined by the two horizontal lines on the screenshot. Small candles and the lack of large wicks lead to a low ATR.
ATR begins to rise because the candles have gotten larger. The ATR continues to increase throughout the entire trend during the next bearish phase.
The ATR reached its highest point as the trend of the bearish movement ended. The sensation stopped going down as the ATR decreased.
In such a situation, the ATR can provide a powerful tool for trend-following investors. The ATR isn’t a trend-following mechanism, but changes in volatility may indicate changes in market behavior.
The addition of an exponential Moving Average to the ATR provides interesting insights as well as an objective application. The EMA appears as a blue line below the ATR window.
The areas highlighted in the chart below represent periods when the ATR is higher than the EMA. Strong market trends characterized both phases.
The trend reversed when the ATR was below the EMA. When the ATR was on top of the EMA, and they were clustered together, the price was in a narrow, sideways phase.
Understanding changes in ATR structures can help traders identify price and trend changes.
ATR can also be used to identify price fluctuations that have reached their limit. The ATR gives us an average range of price movements over a period. We can use this to predict whether trends will continue or stop.
Some markets tend to move in a different way and trend for longer and more than others. The table below illustrates the significant differences in daily pip variations between the different Forex pairs.