Average True Range (ATR): What it is and Its Role in Trading

Everyone wants to know when their favorite cryptocurrency will burst into volatility? And let’s be real, I’m guessing you’re no exception.

The good news is you no longer need to scratch your head. This ATR trading guide will lay down everything you need to know about market volatility so you won’t miss the ride.

The ATR is an indicator that helps traders to measure volatility and can assist you in finding the right markets to maximize profits. The best part, it’s also a good risk management tool to assess the perfect spot for your protective stop loss.

Still, stop-loss orders can be tricky.

If your stop-loss is too wide, you risk losing more money than you might have wanted. On the other hand, if your stop-loss is too tight, you risk being knocked out of your trade prematurely.

The key is ATR must be used in conjunction with a trading strategy to gain a real edge in the market. In other words, it helps investors to use the volatility in their favor and not against them.

So, What Exactly Is The Average True Range?

The average true range is an oscillator-based indicator that measures the market volatility. The ATR can be applied to any time-frame, and it is useful in any market (stocks, futures, cryptocurrencies, forex, more).

But, what’s the point to use ATR?

The purpose of ATR is to provide traders with information about how much an asset can move in a specific period. Hence, to help you get an idea about future volatility and therefore have more tools to manage the open positions according to the market environment.

Additionally, the average true range indicator is used to determine possible price targets, as well as a tool for placing stop-loss orders to have solid risk management.

This indicator suits the cryptocurrency market particularly because of the volatile nature. For this reason, the ATR is perfect to identify the possible price range of cryptocurrencies and help you act and manage your assets based on the information.

For example, in the next daily chart of BTCUSD, we can see how the ATR (lower panel) has increased during the last segment due to the increasing volatility. If traders expect volatility to increase, it should be taken into consideration before establishing the:

• Position size,
• Profit targets,
• Risk management

But, How Does ATR Works in Crypto Trading?

Generally, all indicators used in the Forex or stocks market can be adopted in crypto trading. And ATR is no exception.

ATR works in a way to help you measure the changes in prices (volatility). It doesn’t matter if the price comes from a stock, a commodity, or a cryptocurrency. However, it works exceptionally well in crypto trading mainly because of the high levels of volatility. For example, in the case of Bitcoin, there have been periods where the price has run up to 990% in a year. Also, price plunges drastically, which behaves quite differently than the traditional market.

An interesting fact about ATR is, it is only meant to measure volatility. It should never be used as a buy or sell signal.

That is because the ATR is supposed to give the possible range of movement for a given period. But it DOES NOT define if the range is going to be made to the upside or the downside.

For example, if the daily ATR is $5, that means that the price is likely to have a daily range of $5 during the next session. So, if the price has already made the $5 to the upside, then taking a long position near the high of the day is not ideal. That is because the price has already made the average range for that day, and it is likely that the uptrend could lose momentum.

Therefore, to get the most of the ATR indicator, it must be used in combination with a trading system to get the trading signals. The ATR can be used to filter your entries.

However, before going through an example to clarify these concepts, it is important to notice that there are several ways how the ATR indicator can be drawn on the chart:

1. Below the price chart where the ATR is drawn on a new window.
2. In the same chart, overlying the price action.

In the next example, we draw on the 1-hour BTCUSD chart the daily ATR (14 periods) projections for the day ahead (see red and green lines). The idea of using a lower time frame with the ATR is to define possible areas where the price is likely to find support or resistance.

In this particular example, the ATR is used in combination with price action analysis to find a high probability entry. Here you can see that the price went to the upper limit of the ATR, which means that the price has reached the top of the average daily range.

So, now the idea is to look for a technical indicator to establish a short position.

In this case, the inside down bar provides the entry signal, which is a high probability entry because it is at the top of the ATR of the daily time frame. Here you can see how combining price action with the ATR indicator can provide powerful trades.

Can I Really Use ATR to Find Market Trend?

Trust me, it’s not only you who misinterpreted ATR with a trend indicator. In fact, there are even experts who think that too.

Truth is, ART is a volatility indicator.

Remember, the ATR only illustrates how much volatility there is in the market. Such volatility is not always directional (trending markets) it can be presented in a sideways action.

If you still struggle to wrap your head around it, the next 30-minute BTCUSD chart helps to clarify these concepts.

See how the prices show one downtrend followed by an uptrend? That action can be classified as a sideways market.

Notice that the raise in the ATR illustrates an increase in volatility. In other words, the prices have a bigger range of movement. But nevertheless, that range not necessarily translates into a trending market.

This is one of the reasons why the ATR must be analyzed in conjunction with a trading methodology.

Why ATR Indicator Is So Important?

The ATR is important because it offers the trader a sense of how volatile the market is. Also, based on that information and a solid trading strategy, the trader can have a competitive advantage in front of other traders.

It’s important to remember that the ATR must be used as a filter to take trades in good locations. The best part? It is also a powerful tool for defining stop loss levels and profit targets (these two concepts are explained below).

Should I Use ATR?

The ATR should be used by all market participants regardless of their investment horizon.

Why?

It’s because the ATR indicator is helpful to find high probability trades and have efficient trade management.

For day traders whose executions are on the 5-minute and 15-minute chart, the ideal ATR should be the daily average true range to have a reference of the levels where the price is likely to run.

On the other hand, the ATR for swing traders should be the weekly and monthly average true range as the main references because the holding period of the positions is longer.

Explained: Using Average True Range Correctly

The correct use of the ATR must be done with a solid trading plan, proper risk management, and specific trading criteria. In other words, the proper use of the ATR should be done with more elements. Try including ATR with price movements, other technical indicators, and market context, that validate a position in the market.

ATR Calculation

To calculate the ATR, first, you have to calculate the current true range. These ranges are defined by the highest absolute value chosen from these three formulas:

• Current High – Previous close

• Current Low – Previous close

• Current High – Current Low

In simpler words, we can define the price range of any given period as the difference between the lowest traded price and the highest traded price.

Secondly, the average is calculated taking as reference the true range of the previous periods, by default the ATR takes the last 14 periods for its calculation because its developer J. Welles Wilder, Jr took that number as his main reference; that is why almost all platforms have 14 periods by default. However, this number can be changed in the setting section.

The ATR formula is outlined below:

Current ATR = ((Prior ATR x 13) + Current TR) / 14

What Considers A Good ATR Level?

A good period of calculation for ATR indicator is 14 periods because this is by default the number used by most of the trading platforms out there. So, a great number of retail and institutional traders likely take this level as the main reference.

It is important to always have in mind the 14-period ATR of relevant time frames like the 4h, daily, weekly, and monthly as the eyes of many market participants are in those levels.

Why Use ATR as Stop Loss?

The ATR is usually used as a trailing stop loss system as it allows using the volatility as a measure to protect the current positions in the market. Additionally, it helps to hold the trades for a longer time and get the most from trending markets.

Trailing stops should only be moved in the favor of the current position and never against it. Trailing SL is designed to limit risk and lock in profits without giving back too much of your profits.

The next 15-minutes Bitcoin chart is a good example of how to use the ATR to trail-stop losses.

After the price triggered the short entry at the break of the bearish flag and the market moves in our favor, then you should project the trailing stop level. It is calculated based on the sum of the current closing price and one time* the current ATR:

• Trailing Stop Loss level for a short position = (Current Closing price + 1ATR*)
• Trailing Stop Loss level for a long position = (Current Closing price – 1ATR*)

In this particular example, the trailing stop loss level is drawn by an indicator that projects the level automatically for us (red line). That way, the work of the trader is to move the stop-loss order based on that reference.

Notice how this trailing stop system provided the short trade? It provides enough space to let the position run and take the most from the downtrend movement before a reversal took place.

Using ATR to Set Profit Target

The main advantage of placing targets with the ATR is that it gives clues about reasonable price targets based on the underlying volatility.

The ATR indicator gives a fair approximation of the possible range of the day ahead. But, to fine-tune your exits we need more than the ATR indicator. Setting price targets using the ATR indicator should be done in conjunction with a market structure like support and resistance levels, previous swing high/low points, moving average, more.

The next BTCUSD daily chart with the weekly ATR (14) (red line) is a great example of how to identify targets.

For example, see how after the price made the double bottom, the main two targets were the resistance level A and B. However, the one with more chances of getting reached was area A because this is the point where the Weekly ATR is located, see how immediately the price touch that area it went down.

When we’re in a strong trading market, we can use multiple ATR as the place to take profit. Runaway markets are notorious for overshooting the ATR target.

So, for example, if the current daily Bitcoin ATR is $200, then you could place your profit target 2 or 3 times the ATR value. That would be a $400 or $600 profit target.

Here are the best practices on how to use ATR to set profit targets:

1. Identify market structure, like supports and resistance.
2. Use higher ATR time frames. Depending on your trading style, you could use the daily, weekly, or monthly chart.
3. Choose the profit target where there is a confluence of factors, market structure, and ATR.

Using Average True Range to Spot False Breakout

Another use of the ATR indicator is to spot fake breakouts or fakeouts.

Spotting false breakouts is tricky.

A false breakout usually happens when the price temporarily breaks above (below) a key consolidation pattern, support or resistance level, previous swing high, or swing low but immediately changes direction.

Most of the time, you can only tell if a breakout is real or not only after the fact. But, that’s of no use for traders. Imagine you’ve already missed a boat, so what’s the point of holding onto the hand rails? An easy way around this issue is to use the average true range which is a leading indicator.

The rule number one of trading false breakouts is to look for a divergence signal between the ATR indicator and the price action. In other words, if there is a disagreement between the ATR indicator and the price action, we’re potentially dealing with a false breakout.

For example, if a breakout below a support level is not accompanied by a rising ATR, it often shows a false breakout.

As a general rule, false breakouts tend to happen when the value of ATR is low.

In conclusion, to spot a false breakout using the ATR indicator simply look for these clues:

1. Price has already reached its daily average true range or it’s above the upper limit of the range.
2. The breakout is not accompanied by a rising ATR.

Sample Case: ATR in Crypto Trading

Many times, the best way to understand a concept is through a practical example. In this case, we are going to use the 15-minute Bitcoin chart to show how a trade could be executed and managed.

The entry is based on a moving average system (any technical analysis could be used). Here the long entry was triggered when the fast-moving average (10 SMA) crossed the slow-moving average (20 SMA) to the upside. The initial risk was below the most recent swing low (see the chart).

After the position goes in our favor, the trailing stop should be based on the average true range, which is the green line. So, when the price advances, the ATR line also advances. The trailing stop should always be moved in favor of the trade until the SL is triggered.

The Limitations

The ATR is a powerful indicator to take your trading performance to another level. However, its main limitation is that by itself, it only provides information. But it is not useful to get precise entry signals. It always has to be analyzed in conjunction with a trading strategy to get the most from the indicator. In other words, the ATR is always dependent on a trading strategy or trading system.

Conclusion

In summary, the ATR could be a powerful tool in your trading arsenal to get the most from volatile markets. At the end of the day, the predictive nature of the ATR indicator can provide us with precise risk management parameters and also with reasonable price targets.