ATR is a simple indicator that is often undeservedly neglected by traders. By knowing how to use it right, the traders have an additional way to boost the number of profitable trades and minimize the number of exits by stop loss order.
This article aims to throw light on the key facts about ATR and the specifics of its use, as well as covers common mistakes that should be avoided. This information will help you apply this indicator in your own trading the right way.
2. Mistakes Made When Using ATR
Before we begin dissecting the facts about ATR, first and foremost, we need to figure out what it actually is. In essence, the ATR or the Average True Range is a technical indicator that measures market volatility for a certain time period.
Why do we have to know the ATR? The thing is that the average volatility is not the same for different instruments. It can depend on how popular the instrument is, as well as the specifics of its pricing, the number of factors affecting the price, the news background, etc. After the price of the instrument travelled its ATR, its direction may change or a correction may take place.
That being said, the volatility changes throughout the day and it’s not always possible to spot by eye whether the movement is going to continue in this direction or ran its course. And that’s where the ATR comes to the rescue.
Or rather it gives a cue about movement continuation. Now let’s give this a close look. Suppose the daily ATR for EUR/USD is 80 pips. When launching the trading terminal in the beginning of the European session, you see that the price went up by 20 pips at the market open on Monday, and then travelled 67 pips by 8:00 AM Moscow Time.
Now here’s a question. Will the growth continue or will the price reverse? What should be your steps if the technical analysis is providing an entry point? And what to do if the price in the course of its morning movement broke out the key support level and formed a technical bounce upwards? Will it continue to go up?
As you can see, there are many questions and whether you close your trade profitable or get kicked out by stop loss order depends on how accurately you answer them. And that’s where ATR will come in handy.
Here’s a simple algorithm for applying the average true range in the situation described earlier:
Even though you can find it in the oscillator folder. To be more precise, this is no classical oscillator that demonstrates when the price is going to reverse.
For starters, you can find the ATR indicator in the set of MT4 indicators. To add it onto the chart, click on the ‘Insert’ menu, the 'Indicators' submenu, the 'Oscillators' submenu, and then choose 'Average True Range'.
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The settings window will then appear where we leave the 14-day period by default (daily ATR for 14 days).
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Once we’ve done that, the ATR indicator window will appear under the chart window. By placing the mouse cursor over the indicator line, we can see the value of the Average True Range at the time the cursor points to. In the chart below, the ATR value is 0.0022 which is 22 pips, respectively.
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Please note that the Average True Range is not an indicator that demonstrates overbought or oversold levels. Its line shows the change in volatility values. Accordingly, the indicator reveals the average range at the moment, and does not provide a signal to go long or short.
Aside from the indicator, there is another way to determine the ATR value. You can do that both manually and by eye. Here’s a simple ATR calculation algorithm:
You can use this value in your subsequent calculations.
The ATR indicator not only gives a cue as far as the price range goes, but also allows determining the stop-loss and take-profit orders for intraday trades.
1. It is better to enter the position when the price has travelled no more than 20% of the daily ATR. This will let you maintain 1:3 risk to reward ratio.
2. Factor in the remaining price movement range using ATR when opening a position and placing your stop loss slightly below this level. Don’t be greedy and ‘leave a tip’ to the market.
3. When placing a stop-loss order, market requirements and trading strategy are the things you should rely on. Typically, it relates to the placement of the stop beyond the key level. In case of intraday strategies and certain trading tactics (e.g. a pyramid strategy), you can use an estimated indicator amounting to 20% of the daily ATR.
When answering the question, “What is ATR on the stock exchange?”, we mentioned that the value of the Average True Range may differ in terms of various trading instruments. However, the size of ATR can also change as far as the same instrument goes, depending on the factors affecting it.
E.g. The daily ATR for the GBP/USD pair has expanded against the backdrop of Brexit. When the situation around negotiations between London and Brussels remained tense for several months amidst tight deadlines, the British Pound was extremely sensitive to every upcoming news. In 2014, the ATR for this pair was roughly equal to 100 pips, whereas in January 2020 it expanded to an average of 270 pips.
What does this mean? It is important to keep in mind that ATR calculated for forex is not an invariable. You need to recheck your calculations based on the average daily candlestick in the 14-day selection. If you see that the ATR has expanded, make sure to increase the values calculated based on it. In addition, if you notice that the number of stop-loss orders has increased despite the use of the trading strategy that performed well before and accurate forecast, it is worth recalculating the ATR. It might have changed which is why the stop loss should be increased as well.
Now let's take a closer look at the key mistakes made by the newbie traders when they apply the ATR indicator.
Yes, we have indeed mentioned that this indicator can be used as a cue regarding continuation of the price movement in a specific direction. That being said, you shouldn't forget that ATR is not an oscillator and will not provide you with entry points into short and long positions the way Stochastic or MACD does.
Visually, the ATR indicator line looks similar to Stochastic. However, it does not have any overbought and oversold areas. So, when the line turns upwards from the lower boundary of the ATR or downwards from the upper boundary, you shouldn’t interpret this movement the way you would with classical oscillators. This is simply a decrease in volatility in the momentum.
Continuing with the topic of oscillators, do not look for divergence and convergence signals on the ATR chart and do not try to identify where to enter the long or short positions based on them. Essentially, the Average True Range does not give signals to enter the market. It is just an auxiliary tool used to measure the range of price fluctuations.
The value of the Average True Range is different for various trading instruments. This is why you shouldn’t compare it. This doesn’t provide any insight and is hands down impractical.
Last but not least, it is also a mistake not to use the ATR. Its value provides another filter to help get rid of false entries. You've probably already realized that ATR is easy to use and can minimize the number of exits by the stop-loss orders.
More often than not, traders who stick to strategies that are based on technical analysis find themselves in situations where they actually fail. This may happen even if they follow the trading plan religiously.
E.g. Moving in an uptrend, the price breaks out the key horizontal resistance level. When this happens, you should wait for its confirmation as the support level and then you can go long.
Over time, the trader sees the price rolling back to the level that was broken out and bouncing upwards from it. The price moves in trend, the support level is confirmed, while the next technical target allows placing a stop-loss order that is three times less than the take-profit order. However, you get kicked out of the position by the stop loss, and the breakout of the resistance level turns out to be false despite the rollback and bounce upwards.
Is there a way to avoid this? Yes, and it is by using the ATR. Typically, at the time of the level breakout, the price has travelled the majority of its average daily range, and if you had known this, you could have refrained from entering unprofitably.
If the ATR is not a part of your trading plan yet, make sure to add it to your entry checklist as an additional item. If you have been using this tool for a while now, it’s always a good idea to check whether you are factoring in everything that’s needed.
And be sure to check out Alexander Gerchik’s video below covering the ATR. If anybody could give the best advice on its correct usage, it is a pro trader with 20 years of successful trading experience under his belt.
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