Today we are hitting one of the most important indicators, the ATR (average true range) indicator. Average True Range is the indicator that professional traders use and baby beginners know nothing about it. We’re gonna be covering it right here, right now.
So what do we use the ATR indicator for first off let’s go through the benefit of this little known indicator used by professionals. Let’s be honest, success consists of professional successful currency and commodities traders is not luck for sure. Beginners spend their time looking at RSI, stochastics, MACD or some different well known indicators. A whole host of other indicators and whilst they are important. Nothing, and I mean nothing, has the value of the ATR.
So, today in this blog I’m going to cover that first. So, what do we use it for? Well the ATR indicator is used to identify really explosive trends that are about to break out. In other words it is a great indicator for knowing where the S stands. Average True Range ATR indicator is the best to use in a longer period, for example one year period. That means the price range movement has gotten quite quiet over a long (12-month period). So it means something big is about to happen. The forex market as we know does not stay quiet for long. Let’s jumping into the pictures below to take a look what I’m talking about:
I’m gonna look at the euro dollar currency pair on a daily chart.
ATR indicator setings
First, you will need to add an ATR indicator on the chart. How to do that depends on the trading platform you are using. I’m using the TrendingView platform from dailyfx.com, as you can see in the picture above. First I’ll click on the Indicator button and then type ATR in the search bar.
ATR indicator (average true range) populates the bottom part of the TrendingView window. If I want to change any of the settings on the ATR I would literally move my mouse over to the ATR indicator window, left bottom part on the chart window, and click on the settings icon (gear icon).
Change the number of periods of the ATR indicator. We want to use 10 periods, so we will enter number 10 in the “Length” field.
We’re gonna look over a one-year period so I’ll adjust the zoom on the chart to see one year period. I will set chart zoom to show one about 365 day candles.
NOTE: We are using a Daily chart with ATR10 indicator in a period of one year.
Detecting an explosive market volatility by using Average True Range indicator
Now I’ll stretch the ATR indicator (average true range) window up. So we can see where the peaks and troughs of the indicator are. Because, the point is to see where the multi-year low of the ATR indicator is.
I will mark the lowest point of the ATR indicator line on the chart above. Then I will draw a vertical line to show the point on the price chart correlates with the multi-year low point of the ATR indicator.
If we then look at what happened at that point, we will see the volatility flatten right out of the multi-year low. We then can draw a price range movement, so we can measure price from that range.
We are measuring the range between two price peaks, just before multi-year low and just after it. The measured range is about 387.7 pips.
So, what it really tells us is that volatility is really flattened out. Now it’s got to the low point and generally something is about to happen. After you get to that low point you can certainly see on the chart above, that price is going to break out and we get the volatility moving again.
The currency market is always flowing between low volatility periods of time and higher volatility periods of the time. After that low volatility period always comes high volatility period, which we can see on the picture above. So that’s the first use of the ATR indicator.
How to detect turning point of trend by using Average True Range indicator
Now let’s have a look at another use of the average true indicator. We’re really going to use it to predict market turning points and identify high probability trend reversals. Now, the mark only has a certain average amount of potential energy in any one week. We need to identify market move bigger then 1.5 of ATR. If it’s moved one and a half times more than the ATR, we have been expecting a reversal to happen.
Let’s have a look at that at the chart, below:
For this second use of ATR indicator (average true range) we need to identify a clear trending move of the price chart. In our case that is a bullish trend. We’ll measure two things: difference between low and high on the one swing of the up trend and second one is maximum ATR value for that time period. Time period must be at least one week on the daily chart, as we did before.
In our example the values are:
- Swing is about 700 pips
- Max. ATR value is 91.9
If the swing between low and high price of that time period is a minimum one-and-the-half time higher than maximum ATR value for a given time period, we can assume that trend reversal is coming in the next one or two periods used to measure previous values.
In our example the swing is obviously higher more than one-and-the-half times than the maximum value of the ATR indicator, so the trend reversal we can expect in the next couple of weeks.
If we look at the previous chart we can see that the reversal really happens.
An example of turning point
So, what we are noticing here is that when the price moves in excess. Other words you’ve got an expansion of price range movement which is at least one and a half times. As bigger price expansion is the better opportunity for price reversal is. In our example from the chart above the expansion of the price is 700 / 90 = 7.8 times greater than the maximum of ATR10 in the same time period. That is a very strong signal the price reversal point is coming.
As we can see from the chart above, the turning point event came just two or three weeks after the ATR indicator gave us the turning point signal. In case that price move is not tapped after our prediction, keep going to monitor the market for the next ATR turning point signal.
How to use ATR to set up proper stop loss level
Let me show you another use of the ATR indicator (average true range) which is critically important. Now we can use ATR and the most important uses of the ATR possible. This is about setting up a proper stop-loss. So you live more of a lifestyle trader than being like everyone else that stopped hunting. Now stop hunted means people who set their stop-loss it’s way too close to resistance levels or way too close to support levels. You know it’s highly used it’s very stupid. Different markets of course have different volatilities. So, I will jump to the chart to show you how to trade using nothing more than the price action and support and resistance levels and ATR of course.
At the chart above you can see that the current trend is a bullish trend, but with some period of side move market. We are looking for a bullish breakout and that is normal. But, the question is how to set up the stop loss? Average trader will tell you that a good stop loss set up is the support line (green line) minus 2 or 3 pips. But, in most cases that is not good enough. Some time can happen that the price will break out above the resistance line (red line) and then fall below your stop loss and activate it before it keeps going up again. To avoid that scenario experienced traders use ATR for fine tuning of stop loss level.
Use ATR to exact and safe stop loss value calculation
To set up the right stop loss level I will measure minimum and maximum ATR in the time period when the market goes sideways (between two blue vertical lines) and calculate average value. The average ATR value is: 90.4 + (153.8 – 90.4) / 2 = 122.1 pips. The stop loss calculated in this way is shown as the yellow line on the chart below.
This method of stop loss level calculation in most cases gives your trade more resistance to false stop loss activation. Because in this way we calculate the average of the current price volatility and we are using it as false stop loss activation protection.
Remember this and never again use fixed stop loss values any more. Instead, first you need to detect the support level (in case of a bullish market) or resistance level (in case of bearish market) and after that you will need to calculate the average ATR value and finally make a correction of stop loss value, according to the calculated ATR.
Stop loss as 3 * ATR rule or 5 * ATR rule?
For the medium term trading we are using > 3 * ATR rule for stop loss value calculation. The medium term is trading on the base of maximum 10 candles in the future, from the current time point. Let’s see example on the chart below:
We have a situation where the market goes down or a bearish trend and we make a decision to sell at the current price of 1.10280. The question is how to set up stop loss in the current situation? We do not use any known trading strategy we just decide to sell. In situations like this we will use the >3*ATR rule.
First, we will measure current amount of ATR which is about 0.01184 and multiply it with factor of 3, which is 3 * 0.01184 = 0.03552. If we use >3*ATR rule the final value of stop loss must be greater than: 1.10392 + 3 * 0.01184 = 1.13944.On the chart above the stop loss value (yellow line) is 1.13894 because the price fluctuates and it is very difficult to take a screenshot at the right time, but the difference is not so big and I hope that you understand the concept how to use > 3 * ATR rule.
If we want to trade on the basis of the long term, e.g. more than 10 candles in the future calculated from the current time point the magic number is 5. In other words we will calculate stop loss to be > 5 * ATR.
ATR does not tell you the direction of the trend. It is certainly not a trend indicator. If it moves up doesn’t mean markets are going up. Or opposite. It just means that the open and close prices are getting further apart. It means that there is more confidence in the direction. If the opening and closing prices are closer together it means there is disagreement or it means there is a lack of confidence in that direction. When an opening and the closing price are further apart it means volatility increases and it means there’s confidence in that direction up. Or opposite, if the opening and closing price are closer and closer the ATR is going down and that means that confidence in the current trend direction is going down.
If the market moved more than twice the ATR into an area of support assistance it could snap back in the opposite direction and that essentially means you’re in that expansive phase of a breakout.
Keep in your mind to trade as a professional trader not as beginners and always use ATR to indicate explosive trends, turning points and calculate stop loss as a professional. I wish you many profitable trades in the future.