Developed by Wilder, ATR gives Forex traders a feel of how to read forex indicators the historical volatility was in order to prepare for trading in the actual market. Forex currency pairs that get lower ATR readings suggest lower market volatility, while currency pairs with higher ATR indicator readings require appropriate trading adjustments according to higher volatility.
During more volatile markets ATR moves up, during less volatile market ATR moves down. When price bars are short, means there was little ground covered from high to low during the day, then Forex traders will see ATR indicator moving lower. If price bars begin to grow and become larger, representing a larger true range, ATR indicator line will rise. ATR indicator doesn’t show a trend or a trend duration. Wilder used daily charts and 14-day ATR to explain the concept of Average Trading Range. In other words, it tells how volatile is the market and how much does it move from one point to another during the trading day. ATR is not a leading indicator, means it does not send signals about market direction or duration, but it gauges one of the most important market parameter – price volatility.
Forex Traders use Average True Range indicator to determine the best position for their trading Stop orders – such stops that with a help of ATR would correspond to the most actual market volatility. When the market is volatile, traders look for wider stops in order to avoid being stopped out of the trading by some random market noise. Question is: would you put the same distance Stop for both pairs? Equal distance stops for both pairs just won’t make sense. Look at ATR values and set stops from 2 to 4 time ATR value.
Let’s look at the screen shot below. For example, if we enter Short trade on the last candle and choose to use 2 ATR stop, then we will take a current ATR value, which is 100, and multiply it by 2. Using a simple Range calculation was not efficient in analysing market volatility trends, thus Wilder smoothed out the True Range with a moving average and we’ve got an Average True Range. Normal days will be calculated according to the first equation. 2, where volatility of the day will be measured from the high to the previous close. 3 by subtracting the previous close from the day’s low.
ATR measures volatility, however by itself never produces buy or sell signals. It is a helping indicator for a well tuned trading system. For example, a trader has a breakout system that tells where to enter. Wouldn’t it be nice to know if the chances to profit are really high while possibility of whipsaw is really low? Yes, it would be very nice indeed. ATR indicator is widely used in many trading systems to gauge exactly that. Let’s take a breakout system that triggers an entry Buy order once market breaks above its previous day high.
Let’s say this high was at 1. Without any filters we would Buy at 1. 3002, but are we risking to be whipsawed? EURUSD 14 day ATR stands at 110 pips.
Instead of entering here and now without knowing whether the level will hold or give up, traders use ATR based filter. For example, if support level is breached at 1. Another common approach to using ATR indicator is ATR based trailing stops, also known as volatility stops. The best description of ATR I have seen so far.