How the Average True Range (ATR) indicator can enhance your risk management

Released in 1978 by John Welles Wilder Jr, the Average True Range indicator, commonly referred to as simply ‘the ATR,’ is a technical analysis tool typically used to measure the price volatility of a financial asset.

Introduced alongside the likes of the RSI, ADX, and Parabolic SAR in ‘New Concepts in Technical Trading Systems,’ a book written by Wilder in the late 1970s, the ATR measures current price volatility using a series of calculations, attempting to find the ‘true range’ of recent price action.

With a range of possible uses, traders can incorporate data from the Average True Range indicator into their trading strategy to better understand current market conditions and manage risk.

• An objective measure of volatility: By virtue of its calculation, the ATR offers an accurate and objective measure of price volatility. With this information, traders can better make informed decisions about prospective and currently held positions.
• Dynamic stop-loss and take-profit targets: Whether done manually or automatically through trading software, data from the ATR can be used when placing stop-loss and take-profit orders. For example, if the markets are currently reported volatile, you may want to allow for more ‘breathing room’ before your trade is either stopped out or hits your target.
• Identifying changes in trend: Especially when in periods of consolidation, a sustained increase in the ATR’s value could suggest a potential change in trend or breakout.

• The ATR is a lagging indicator: Although useful in various applications, the ATR is not without its limitations. As a lagging indicator, the ATR bases its readings on historical data, which may not accurately predict future conditions.
• False signals: Even when market conditions are reported as increasingly volatile, this does not always constitute the right conditions to trade. As such, traders should combine other forms of analysis with the ATR to determine whether price is moving erratically or is following a trend.
• No directional bias: Albeit by design, the ATR does not suggest whether price is more likely to go long or short. Unlike other indicators, the ATR must be coupled with different forms of analysis to ascertain directional bias.

The formula to calculate ATR value is as follows:

ATR = (Previous ATR * (n - 1) + TR) / n

When simplified, we must start by finding a single candle’s ‘true range.’ The ‘true range’ will always be the greatest number of the following calculations:

1. Current candle high - current candle low
2. Absolute value of current candle high - previous candle close
3. Absolute value of current candle low - previous candle close

Let’s put this into practice with the following example:

Current candle high - current candle low

1.04615 - 1.04009

=0.00606

Absolute value of current candle high - previous candle close

1.04615 - 1.04458

= 0.00157

Absolute value of current candle low - previous candle close

1.04009 - 1.04458

= 0.00449

0.00606 = greatest number

0.00606 = true range

Then, the above reading must be averaged across a pre-determined time frame within the indicator settings. By default, this is 14-period, meaning an average will be taken across the last 14 candles:

In the above example, candle #15 has an ATR reading of 0.00824, or 82.4 pips. This means that the price has moved an average of 82.4 pips in the previous 14 candles.

Reading the Average True Range indicator is relatively straightforward:

• High ATR reading: If the ATR reports a sustained period of high readings, we can assume the markets are volatile. Given that markets need volume to trend, such conditions may offer an opportunity for the market to trend, form a reversal, or break out from previously held consolidation.
• Low ATR reading: If the ATR reports a sustained period of low readings, markets can be assumed to be low in volatility. A lack of price movement can often be linked to periods of low volume, like public holidays, which are not the best time for most trading systems to trade.

Generally speaking, traders will use the Average True Range indicator to gauge market conditions, hoping for increasingly volatile or pre-existing periods of high volatility.

As a part of a balanced trading system, the Average True Range indicator has many potential uses. Here are a few examples:

1. Volume indicator: With the market needing volume to move decisively, the ATR can be used to ‘pre-screen’ potential trading opportunities. For example, if other elements of your trading system are giving a signal to trade, readings from the ATR can help gauge whether there is sufficient volume.
2. ATR trailing stops: Either when placing a trade or managing an open position, where you put your stop-loss is a significant factor in determining the success of your trade. Using the ATR’s value, traders can set a trailing stop at a multiple of the ATR (1.0x, 1.5x, 2.0x). Using this approach, traders can ensure that their trade has enough room to ‘breathe’ without being stopped by market noise, even during volatile conditions.
3. Exit indicator: While managing an open position, the ATR can be used to gauge changes in trading conditions. If the ATR’s value begins to fall while holding a position, this may suggest the current market move has been exhausted, and the price will now enter a period of consolidation. To secure profits and free up margin, traders can use the ATR to exit trades, especially for those looking to trade intraday.
4. Position sizing: The ATR can be used to determine the correct position size for your current level of risk as part of a risk management system. For example, you can use a multiple of the ATR to judge where your stop is to be placed. Then, having determined what percentage of your account to risk, traders can work backward to determine the correct position sizing.

A mainstay of technical analysis for the best part of fifty years, the Average True Range indicator is a valuable tool for gauging market volatility and better understanding current market conditions.

When used correctly and combined with other forms of analysis, the ATR can be a powerful tool for any trader’s arsenal - however how you choose to use it.

Footnotes

¹New Concepts in Technical Trading Systems, J. Welles Wilder, 1978