Introduction
As a trader, one of the most important things you need to know is how to measure volatility. Volatility is a measure of the magnitude of price movements in a particular asset or market, and it is essential to understand because it affects your risk and reward. One popular tool that traders use to measure volatility is the Average True Range (ATR).
What is the Average True Range?
The Average True Range (ATR) is a technical indicator that measures the volatility of an asset or market. It was developed by J. Welles Wilder Jr. and first introduced in his book, “New Concepts in Technical Trading Systems.” The ATR is calculated using a formula that takes into account the range of price movements over a certain period of time.
How is the ATR Calculated?
The ATR is calculated using the following formula: ATR = [(Prior ATR x 13) + Current True Range] / 14 The “True Range” is the greatest of the following: – The current high minus the current low – The absolute value of the current high minus the previous close – The absolute value of the current low minus the previous close
What is the Purpose of the ATR?
The purpose of the ATR is to provide traders with a measure of volatility that can be used to determine the size of the stop loss order, as well as the potential profit target. In other words, the ATR can help traders set their risk and reward parameters.
Using the ATR in Trading
How to Use the ATR to Set a Stop Loss
To use the ATR to set a stop loss, you need to first determine the average true range of the asset or market you are trading. Once you have calculated the ATR, you can then use it to set your stop loss order. A common strategy is to set the stop loss at a multiple of the ATR away from the entry price. For example, if the ATR is 10, you might set your stop loss 2x or 3x the ATR away from the entry price.
How to Use the ATR to Determine Profit Targets
The ATR can also be used to determine profit targets. One strategy is to set a profit target at a multiple of the ATR away from the entry price. For example, if the ATR is 10, you might set your profit target at 2x or 3x the ATR away from the entry price.
Using the ATR with Other Indicators
The ATR can also be used in conjunction with other indicators, such as moving averages or trend lines. For example, if the ATR is increasing while the price is above a moving average, it may indicate a bullish trend. Conversely, if the ATR is decreasing while the price is below a moving average, it may indicate a bearish trend.
The Pros and Cons of Using the ATR
Pros
– The ATR is a reliable measure of volatility. – It can be used to set stop loss orders and profit targets. – It can be used in conjunction with other indicators to determine trends.
Cons
– The ATR does not provide information on the direction of the trend. – It can be affected by sudden price spikes or gaps. – It can be difficult to determine the optimal multiple to use for stop loss and profit targets.
Conclusion
The Average True Range is a useful tool for traders who want to measure volatility and set risk and reward parameters. It can be used to set stop loss orders and profit targets, and it can be used in conjunction with other indicators to determine trends. However, it is important to be aware of the limitations of the ATR, and to use it in conjunction with other tools and strategies to make informed trading decisions.
