Investors must consider several parameters when determining the type of asset or security to trade. One of these parameters is volatility, which determines Return on Investment (ROI) expectations and the associated risk of an asset. Generally, an asset with higher volatility is considered riskier, and vice versa.
Regardless, traders can take advantage of volatile assets to potentially make more profit. The Average True Range (ATR) can be a convenient way for traders to assess an asset’s volatility, which will help them determine their strategy and approach to a trade.
What Is The Average True Range (ATR)?
The Average True Range (ATR) is a technical indicator used to easily measure an asset’s volatility. It is calculated using the true range, which is the highest of the following values:
- The difference between today’s high and low.
- The difference between today’s high and the previous day’s close.
- The difference between today’s low and the previous day’s close.
To Calculate The ATR:
Step 1: Calculate the true range for each day using the formula above.
Step 2: Technical analysis expert, J. Welles Wilder, explained that the ‘true range’ of an asset must consider previous closing prices. Based on this, If there is no previous ATR value, take the sum of the true ranges for the last n days (usually 14) and divide by n to get the initial ATR.
Step 3: For subsequent days, use the formula:
Current ATR = [(Prior ATR x (n-1)) + Current TR] / n
Where n is the number of periods (usually 14)
Thankfully, you do not need to calculate this value yourself. You can easily get your ATR with your preferred online trading platform and apply it to the bottom of your charts. You only need to add one input, which is the number of periods (usually 14) being evaluated.
Understanding Market Volatility
Volatility is often used to describe an asset’s uncertainty or risk. It refers to the frequency (how often) and the magnitude (how high) of an asset’s price changes. Higher volatility means that an asset’s price can move dramatically over a short period. This change can be in either direction and is usually determined by liquidity.
How To Use ATR To Simplify Measuring A Market Volatility
It’s relatively easy to interpret and implement ATR readings. When the ATR value increases, it simply means the volatility of that asset has also increased. Similarly, when the ATR value decreases, the volatility of the underlying asset decreases.
Volatility can vary depending on the type of asset or a specific period, and ATR helps track these changes. For example, assets like cryptocurrencies experience higher volatility, especially during significant market events or announcements. Historically, periods such as the release of major economic reports or regulatory updates have been associated with increased volatility.
Benefits of Using an ATR
1. To determine if the asset is right for you
ATR serves as a clear metric to determine the volatility of a security. Assets with a high ATR indicate higher volatility and might be unsuitable for conservative traders who prefer lower risk. Similarly, traders with a higher risk appetite might find such assets more appealing because of the higher profit potential.
2. To profit using the breakout strategy
Most traders would agree that breakouts can present some of the best trading opportunities for any particular asset. The idea is to look for assets with relatively stable prices denoted by a low ATR, signifying a low-volatility market. When prices consolidate, breakouts follow. Low volatility phases are typically followed by breakouts, which the ATR helps traders anticipate. The ATR allows traders to join the new trend from its onset for maximum profit.
One method is to:
a. Examine a weekly chart for periods where the ATR and volatility are at multi-year lows.
b. Identify the price range during this time or pinpoint the strongest support and resistance levels.
c. Then, wait for the price to break out from this range or the identified levels and capitalize on the trade.
Another approach is to open a position whenever the price moves more than 1 ATR from the previous session’s closing price. This strategy is effective because a move greater than 1 ATR often indicates a change in volatility, which usually leads to the asset continuing to move in the same direction.
3. Improved risk management
Good risk management techniques help traders protect their position when trading financial markets. One critical aspect of risk management is position sizing. It involves assigning appropriate lot sizes to different assets to help reduce traders’ risk exposure and improve their profit significantly. Generally, assets with high ATR (high volatility) should be traded with reduced position sizes, and assets with low ATR (low volatility) should be traded with larger lot sizes.
4. To identify exit points
This method places a trailing stop order beneath the highest high the asset has reached since entering the position. The distance between the highest high and the stop-loss level is defined by a multiple of the ATR. While the ATR can serve as a useful exit point, it is recommended that the exit level be confirmed with other technical indicators to validate the decision further.
Common Mistakes To Avoid
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1. Linking increasing ATR to price growth
ATR alone will not show the price’s direction. When ATR value increases, this can either be due to a price increase or a decrease.
2. Expecting ATR to show whether or not a trend is about to reverse
Again, ATR readings only measure market volatility and will not tell you optimal entry and exit points. ATR should be used with other technical indicators, such as the moving average, which will act as a signal line. For example, when the ATR crosses the signal line, confirming an uptrend, traders should buy at this level to take advantage of the trend. Similarly, when the ATR goes below the signal line, it confirms a downtrend, and traders should place sell orders at this level.
The Role of ATR in Trading
The average true range (ATR) determines an investment’s price volatility. It can help traders determine if an asset aligns with their risk tolerance, develop effective entry and exit strategies, and manage their positions more effectively. However, it’s important to remember that ATR is not a standalone indicator; it should be used with other technical tools to gain a comprehensive view of market conditions.