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A Basic Guide to Using the Average True Range Indicator

When it comes to trading, there are a multitude of different technical indicators that can be used in order to make informed decisions. One such indicator is the Average True Range, or ATR. In this article, we’ll take a look at what the ATR is, how it’s calculated, and what it can tell you about a particular asset. We’ll also discuss how to use the ATR in conjunction with other factors in order to make trading decisions, as well as some of the pros and cons of using this indicator. 

What Is the Average True Range?

The ATR is a measure of volatility that takes into account both price movements and gaps. To calculate the ATR, you take the most recent period’s high price and subtract the most recent period’s low price. If this number is positive, you then add it to the absolute value of the difference between the current period’s high price and the previous period’s close price. If this number is negative, you simply take the absolute value of the difference between the current period’s high price and the previous period’s close price. You then take the average of these numbers over a specified time period, typically 14 days.

The ATR can be used to gauge both overall market volatility as well as the volatility of a particular asset. In general, an asset with a higher ATR is considered to be more volatile than one with a lower ATR. This can be helpful information for both short-term and long-term traders. For example, if you’re looking to buy a stock that you think has potential for significant price appreciation, a stock with a high ATR would likely be a better choice than one with a low ATR. On the other hand, if you’re looking to buy a stock and hold it for the long term, you might want to avoid stocks with extremely high ATRs, as they tend to be more volatile and therefore more risky.

This tool was created by J. Welles Wilder Jr. in his book, New Concepts in Technical Trading Systems, which was published in 1978. In the book, Wilder outlines a number of different technical indicators, including the Relative Strength Index (RSI) and the Parabolic SAR.

Wilder designed the ATR with commodities and futures in mind, but it can be applied to any type of asset. When using the ATR, Wilder recommended a 14-day time period, but this can be adjusted to suit your needs. Some traders prefer longer time periods, such as 21 days or even 50 days, while others may opt for shorter time periods, such as 7 days or 10 days.

The ATR can also give a trader an indication of what size trade to put on. For example, if a stock has a high ATR, the trader might want to consider putting on a larger position than they would if the stock had a low ATR.

Factors to Consider While Using ATR

There are a few things to keep in mind when using the ATR.

First, it’s important to remember that the ATR is a lagging indicator, meaning it will only tell you about past volatility and not future volatility.

Second, the ATR can sometimes give false signals. For example, if a stock has been volatile for an extended period of time, its ATR will likely be high. However, this doesn’t necessarily mean that the stock is going to continue to be volatile.

How to use Average True Range to make trading decisions

While the ATR is a lagging indicator, it can still be helpful in making trading decisions. Here are 3 ways to use the ATR when trading stocks:

1. ATR with price action strategies

One way to use the ATR is in conjunction with price action strategies. Price action is a type of technical analysis that focuses on the movement of prices, rather than on indicators. Price action strategies can be used to make both long-term and short-term trading decisions.

For example, let’s say you’re looking at a stock that has been in a strong uptrend. However, you notice that the stock has been getting more volatile, as evidenced by an increase in its ATR. This might be a sign that the uptrend is losing steam and that you should exit your position.

On the other hand, if you see a stock that has been in a downtrend and its ATR is decreasing, this might be a sign that the stock is starting to stabilize and that it could be due for a rebound.

2. ATR with other indicators

The ATR can also be used in conjunction with other technical indicators. For example, some traders like to use the ATR with the RSI or the Stochastic Oscillator.

When using the ATR with other indicators, you can either look for confirmation of signals or use the ATR as a filter. For example, if you see a stock that is oversold according to the RSI but its ATR is very low, this might be an indication that the stock is not as oversold as it appears to be.

3. ATR with support and resistance

Another way to use the ATR is in conjunction with support and resistance levels. For example, if you see a stock that is trading near a key support level, you might want to wait for the ATR to increase before entering a trade. This would give you confirmation that the stock is starting to become more volatile and that there is potential for a breakout.

Pros and cons of using Average True Range

Like any technical indicator, the ATR has its pros and cons.

Some of the advantages of using the ATR include:

It is Easily Accessible: You can find the ATR on most charting platforms and this makes it easy to use.

It is a versatile indicator: The ATR can be used in a number of different ways.

It can help you manage risk: Because the ATR tells you how volatile a stock is, it can be helpful in managing your risk.

 

Some of the disadvantages of using the ATR include:

Lagging indicator: As we mentioned earlier, the ATR is a lagging indicator, which means it will only tell you about past volatility and not future volatility.

False signals: The ATR can sometimes give false signals, especially when a stock has been volatile for an extended period of time.

Alternatives to using Average True Range

If you’re looking for an alternative to using the ATR, you might want to consider the following options;

1 Bollinger Bands

The Bollinger Bands are a technical indicator that consists of three lines: a simple moving average and two upper and lower bands.

The Bollinger Bands can be used in a similar way to the ATR. For example, if you see a stock that is trading near the upper band, this might be an indication that the stock is overbought and due for a pullback. Bollinger bands are a popular technical indicator and they are available on most charting platforms.

2 Standard Deviation

Standard deviation is a statistical measure that can be used to calculate how volatile a stock is. Like the ATR, standard deviation will tell you about past volatility and not future volatility.

Standard Deviation

Standard deviation is a statistical measure that is used to calculate the dispersion of a set of data points. In other words, it tells you how far away the data points are from the mean or average.

For example, let’s say you’re looking at a stock that has a mean price of $100 and a standard deviation of $10. This means that the data points are dispersed evenly around the mean and that most of the data points are within $10 of the mean.

To calculate standard deviation, you first need to calculate the variance. The variance is calculated by taking each data point and subtracting the mean. Then, you square this number and take the average.

Once you have calculated the variance, you can then take the square root to calculate the standard deviation.

3 Average Directional Index (ADX)

The ADX is a technical indicator that is used to measure the strength of a trend. The ADX can be used in a similar way to the ATR. For example, if you see a stock that is trading above the 25 level, this might be an indication that there is a strong uptrend in place.

How Does ADX work?

The ADX is calculated using two other technical indicators, the +DI and the -DI. These indicators are used to measure the strength of the uptrend and downtrend, respectively.

The ADX is a smoothed version of the DI difference and is plotted as a line on a separate window below the price chart.

When the ADX is above 25, this generally indicates that there is a strong trend in place. When the ADX is below 25, this generally indicates that there is no clear trend.

5 Steps to Trading With the average true range Indicator

Now that you know what the ATR is and how to calculate it, it’s time to learn how to use this valuable information to improve your trading.

  1. Learn a Strategy With average true range indicator

The first step to trading with the ATR is to find a strategy that uses this indicator. There are many different strategies that you can use, but make sure that you understand how the ATR works before using it in your trades. You can also combine the ATR with other indicators to create a more robust strategy.

  1. Create a Trading Plan

Once you have selected a strategy, it’s time to create a trading plan. This plan should include your entry and exit points, as well as your stop-loss and take-profit levels. Make sure that you backtest your plan before using it in live trading.

  1. Use the ATR in Your Trades

When you are ready to start trading, make sure that you use the ATR in your trades. This indicator can help you find better entry and exit points, as well as improve your risk management. Remember to always stick to your trading plan, and don’t let the ATR dictate your entire trade.

  1. Monitor the ATR

After you have placed your trade, it’s important to monitor the ATR. This will help you determine if your trade is still valid or if you need to adjust your stop-loss or take-profit levels. 

A stop-loss is an order that you place with your broker to close a trade when it reaches a certain price. This type of order is important because it helps you limit your losses in a trade. For example, if you buy a stock for $100 and place a stop-loss at $95, then your broker will close the trade if it falls to $95.

Generally, you want to place your stop-loss below recent support levels. This will help you stay in your trade as long as possible while still protecting your capital.

A take-profit is an order that you place with your broker to close a trade when it reaches a certain price. This type of order is important because it helps you lock in profits in a trade. For example, if you buy a stock for $100 and place a take-profit at $105, then your broker will close the trade if it rises to $105.

Generally, you want to place your take-profit above recent resistance levels. This will help you maximize your profits in a trade while still giving the market room to move.

  1. Adjust Your Strategy

As you become more familiar with the ATR, you may want to adjust your trading strategy. You can do this by adding other indicators, changing your stop-loss and take-profit levels, or adjusting your entry and exit points. Remember to backtest any changes that you make to ensure that they are effective.

To sum up, the Average True Range (ATR) is a technical indicator that measures volatility. The ATR can be used in a number of different ways, such as confirmation of price action signals or as a way to manage risk.