First introduced in 1978 in the book New Concepts in Technical Trading Systems by J. Welles Wilder, the average true range (ATR) indicator has long been a valuable tool for technical traders of all asset markets.
Although Wilder’s originally intended the average true range indicator to serve as a measure of commodity price volatility, the indicator has since been applied to trading forex currency pairs.
Keep reading if you’re interested in knowing what does average true range mean and how you can apply the ATR indicator to improve your forex trading success.
What is Average True Range?
The Average True Range or ATR indicator gives a forex trader a sense of recent market volatility. As the image below shows, the ATR does this by rising and falling in response to the level of exchange rate swings that have occurred in the market over a particular timeframe.
Wilder originally developed the ATR indicator as a volatility measure, and many successful forex trading systems now use this indicator to provide a sense of the current level of trading risk in a currency pair.
A low value of the ATR indicator for a currency pair signals that peaceful, ranging market conditions have likely prevailed in the recent past. In contrast, a high ATR value suggests a greater near-term incidence of sharp exchange rate swings or volatility. An unusually high ATR might mean that a dramatic crash or spike has recently occurred in a currency pair’s exchange rate.
Why is the ATR Important?
Instead of showing which direction a currency pair’s exchange rate is moving in, the ATR is typically and ideally used by forex traders to measure the degree of exchange rate volatility a currency pair displays over a recent historical period.
The ATR calculation is relatively simple to perform, so it has benefits for those technical forex traders looking to compute the indicator themselves. Also relevant is that many popular online forex trading platforms like the MetaTrader 4 and 5 platforms from MetaQuotes include and calculate the ATR as part of their intrinsic technical analysis functionality.
In practice, currency traders often consider the ATR indicator an important measure of the risk prevailing in the forex market that can be used to size their positions or forecast trend reversals for a particular currency pair.
How to Calculate Average True Range
The ATR is calculated by taking a moving average of the True Range. This average is usually performed over 14 time periods, which is the time period parameter that Wilder originally suggested.
The True Range for the current time period n or TR(n) is the maximum of three market-determined exchange rate differences or ranges. It is computed using the following equation:
TR(n) = MAX [{High(n) - Low(n)},{Close(n-1)- High(n)},{Close(n-1) - Low(n)}]
You might note that the first range is just the high minus the low exchange rates observed for time period n. The second range is the closing price of the exchange rate for the previous period (n-1) minus the high exchange rate for period n, while the third range is the previous close minus the low exchange rate for period n. The True Range for period n or TR(n) is just the maximum or highest of these three ranges.
The ATR for time period n averaged over p time periods can then be calculated as some form of moving average of the True Range. Using a simple moving average (SMA), the ATR equation would look as follows:
ATR(n, p) = SMA(TR(n), p)
where the SMA of the True Range for the current time frame n or TR(n) is averaged over p previous time periods. A simple moving average computed over n periods is calculated as follows:
SMA={A1+A2+...+An}/n
Some forex traders use different types of moving averages in their ATR calculation, possibly using exponential, weighted or smoothed moving averages instead of a simple moving average. They might also experiment with performing the moving average over a different number of time periods by varying the p parameter which is typically set to 14.
Advantages of Using Average True Range in Forex
Having a good sense of the prevailing market volatility in a currency pair before you plunge in to take a position can save your trading account from disaster. The ATR not only provides you with a helpful numerical estimate of current volatility but plotting it under the exchange rate in the indicator box can show you how volatility has varied over time in that pair, among other benefits discussed further below.
Identifying Market Moves
The ATR indicator does not show you the direction of exchange rate moves, but it instead helps you measure the extra market volatility that can result from gaps and limit up or down moves. The ATR can also help you quickly see how much a market typically moves on any given day. This volatility measure lets you identify meaningful market moves and size your positions more prudently.
The ATR might also be used as a forecasting tool to indicate the chances of a counter-trend market move or reversal. For example, if the ATR value reads high, that could indicate a greater probability of a directional change that often comes after a period of high volatility. On the other hand, if the ATR was reading low, that would tend to indicate a weak trend and a ranging market.
The ATR does not give frequent trading signals, but when they do occur, it generally suggests that a significant breakout price move to the up or downside has taken place. Also, if the exchange rate closes more than an ATR away from its most recent market close, then a trader can reasonably infer that volatility has risen along with the risk of staying in or entering the market.
Position Sizing
Currency traders can use the ATR to size their positions. For example, a general rule of thumb a forex trader might include in their trade plan to size positions could involve risking 2% of their trading account balance and up to one ATR distance on each position in a currency pair.
Accordingly, if they had a $10,000 margin account size, then 2% of that balance would be $200 that they are willing to put at risk on any single trade. If one ATR distance for a particular currency pair is 50 pips or 0.0050, then they could take a position of $200/0.0050 = $40,000 or 40 mini lots of $1,000 each.
Keep in mind that a higher ATR value generally suggests that you should take a smaller trading position to maintain a consistent level of risk among positions taken in different markets or currency pairs. Conversely, a lower ATR value would indicate that taking a larger trading position might make sense since volatility risk is currently low.
Setting Stops and Limits
The ATR can be used as part of market entry and exit methods to determine where to set profit targets as well as stop losses. For long trades, a trader might enter when the price pulls back to the ATR support level as determined by one ATR distance from the present exchange rate. For short trades, a trader might enter when the price rallies to the ATR resistance level.
Another example is the "Chandelier Exit" developed by Chuck LeBeau that uses the ATR. This stop-setting exit strategy is based on the idea that trend reversals are likely once a market moves against the existing trend by three times the average volatility. This technique can be applied irrespective of where or how the trade entry decision arose.
Those using this exit strategy typically put a trailing stop below the most recent high point the market made since the trade was entered. The difference between that recent high and the trailing stop level entered to exit the trade is calculated as some multiple of the ATR that is used as a measure of the average volatility.
What is a Normal ATR Level?
To a forex trader, the normal or average ATR level will largely depend on the currency pair analyzed. This level can usually be assessed mathematically by taking a simple average of the ATR or visually by plotting the ATR over a several-year timeframe and seeing what level of the indicator seems most central.
For example, if the currency pair usually has an ATR of around 0.01 and its ATR currently reads at that level, then it is behaving normally and exhibiting a normal level of volatility and associated market risk.
On the other hand, if the pair’s ATR has doubled to read at 0.02, then it might suggest that the notable rise in volatility should be looked at more closely in case the market has broken out of a pattern and trading risks have risen as a result, or some other factor is sparking volatile trading conditions.
Alternatively, if the ATR falls substantially below its average, then this move might suggest a calm and ranging market that might show little profit potential for trend traders, swing traders, day traders or others who use strategies that profit from market moves.
Frequently Asked Questions
What is the purpose of average true range?
The average true range (ATR) is a technical indicator used by financial market traders as a measure of the recent market volatility observed for an asset.
Why is ATR better than FTIR?
In finance, the acronym ATR refers to the Average True Range indicator developed by J. Welles Wilder that serves as a measure of market volatility. This ATR is unrelated to the ATR or Attenuated Total Reflectance technique that might be compared to Fourier Transform Infrared (FTIR) spectroscopy, used to measure the infrared spectrum of a substance.
What does a high ATR mean?
In finance, a high ATR means that the asset has been trading in a more volatile manner than usual over the time period analyzed.