Forex traders often try to predict future position changes in the currency market. This helps them pick out profitable points, allowing them to enter the market and invest. However, a prediction is not as simple as it sounds because no one knows precisely what will happen in the future.
Nevertheless, as a trader, you don’t have to see into the future to know what is going to happen. Financial markets are heavily reliant on data, and when you interpret this information correctly, then even you can peer into the future.
Indicators such as the Average True Range (ATR) come into play when processing and pointing out useful positions to trade. The ATR indicator is a powerful tool that, when harnessed correctly, will aid traders to hone their trading approach in the search for profit.
The Origin Of The ATR Indicator
Unlike the forex market, ATR has been in existence for decades and was initially introduced into the trading scene alongside true range indicators to measure market volatility. J. Welles Wilder Jr is credited with ATR concepts in his book, ‘New Concepts in Technical Trading Systems.’
Understanding The Average True Range Indicator
ATR is used in technical analysis to measure market volatility. Market volatility occurs as a result of the change in the value of a stock or currency. The range of a stock or other trading option is obtained from the difference between the highest and lowest price of the stock on a specific day.
Therefore, a broad range often means that the market has high volatility, as its likelihood to shift positions is high. Similarly, the opposite happens in the case of low ranges.
Calculate ATR
Since ATR deals with price ranges, the principle behind this indicator involves differences.
Therefore, find the true range values for a trading item, which is generally gotten from the difference in its high and lowest prices.
An encompassing true range is selected from the most substantial value among the following:
- Current high less the previous close
- Current low less the previous close
- Current high less the current low
From the true range, ATR can then be computed by getting the average true range value for a given length of time, with 14 days being the norm.
How To Employ An ATR Indicator In Trading
At the time of its introduction, ATR was designed to work in the commodities market. However, as other trading markets experience volatility to a varying degree, ATR can also be implemented in these other ones.
1. Make trading decisions
ATR indicates asset price movements which traders can use to determine the viability of conducting a trade. Additionally, analyzing ATR will inform a trader on the magnitude of trade required.
2. Decide when to enter and exit a market
An ATR indicator will enable a trader to figure out how volatile an asset is by calculations on historical data on the same. However, it is worth noting that it doesn’t measure market trends, but merely uses them to plot volatility. Market volatility is always fluctuating as it moves from a low volatility period to a high one.
The ever-changing nature of volatility means that traders can expect a high volatility period after a low one and vice versa. Once you have identified multi-year low volatility, determine the range at the time then trade when it breaks.
Nevertheless, before you enter a market, consider other indicators and factors at play. The ATR shouldn’t be your sole trading guide but rather a complement to your existing strategy.
3. Mitigate against unfavorable prices
In the case of a market exit, ATR is a common factor when deciding when to sell. One way to exit a trade is through a trailing stop loss. By engaging it, you will able to halt an unfavorable price movement and mitigate against losses.
The ATR is a handy tool traders use to identify where their trailing stop loss will lie. You can use an ATR and be directly involved or you can opt for ‘Chandelier stops,’ another trading indicator. The indicator automatically trails your stop loss.
Advantages Of ATR
Despite being long in the tooth, the ATR indicator holds out impressively on its own. Traders today consider the tool as they can be used with any time frame. This is especially key for day traders who rarely hold trading positions for more than a single day. You can use 15, 10, and 5-minute time frames to compute them.
ATR varies depending on how the value of trading options move. As such, they are favorable as opposed to using a fixed percentage. A shift in volatility results in similar movements in the trading range. This movement adjusts the price level distance between stop and closing, allowing the trader to strike a balance between his profits and the stock movement.
Shortcomings Of ATR
· ATR Only measures volatility
One of the average true indicator’s weak links lie in its principle mechanism. Because it only measures volatility, ATR will not indicate how an option’s price is moving. Mixed signals will be sent out and cause uncertainty among traders.
· ATR is open to interpretation
ATR figures do not give a definitive picture of the prevailing trend, and so different traders will hold varied opinions. When using ATR, you must relate the current data with previous records. This should confirm the validity of a trend.
With its merits, ATR is not a foolproof trading indicator. These shortcomings betray the need to combine your trading strategy with other indicators to not only boost your confidence while trading but also to possess an infallible strategy that will make you a profit.
There is no limit to what traders can achieve by using the ATR indicator. Long-term traders, for instance, can use the value to monitor the market. Remember, a period of high volatility leads to one of low volatility and vice versa.
Therefore, by monitoring the goings-on, you could ready yourself for whatever period that follows. Trading losses hit hardest when you don’t expect them. Thus, ATR is valuable for you to ride through turbulent market periods safely.