Would you like to be able to know how many pips a currency pair is likely to move over a given period – be it a day, an hour, or even a minute?
Using the average true range (ATR) indicator, you can. The ATR is a volatility indicator that tracks changes in the price of a currency pair over a range of time frames. In this post, we’ll take you through how it works and how to use it.
Analyzing The ATR Indicator
Before we go any further, let’s discuss something that the ATR can’t do – it does not indicate which direction a currency pair is likely to move. It can, however, give you an idea of its overall volatility - something very useful when planning your trade.
The ATR indicator moves up and down depending on the price movement of a given currency pair. The ATR reading is usually calculated at the end of a given trading period. For example, the ATR is calculated every hour in an hourly chart, while it is calculated at the end of the day on a daily chart. Given that each currency pair is priced differently, the ATR of one currency pair cannot be compared to that of another currency pair.
If you want to calculate the ATR manually, you first have to calculate the True Range (TR)
The TR is the greatest value from the three calculations below:
- The difference between the current high and the current low
- The difference between the current high and the previous close
- The difference between the previous close and the current low
It does not matter whether the greatest outcome is a negative value as traders should use the absolute value in their calculations. These values are recorded on a daily basis for the daily chart and then the average value is determined depending on the number of time periods selected.
The formula for a 14-day ATR is:
ATR = [(Prior ATR x 13) + Current TR] / 14
Don’t worry about having to do this every time you actually use the tool, however. MetaTrader 4 and MetaTrader 5 will do all the calculations for you once you specify the time period that you prefer. Knowing how ATR is calculated is useful, however, in order to give you a sense of how this indicator works.
How To Set Stop-Loss And Limit Orders Using The ATR
Using the ATR can give you an advantage when setting trailing stop losses because it gives you a better idea of – and a way to accommodate for – the natural volatility of a currency pair.
You can use the ATR to set a trailing stop-loss order on either your long or short trades once you have calculated the most accurate ATR reading for your trading time-frame. The most common method for setting a trailing stop loss is to identify the ATR at the time you are setting your trade, then place the stop loss at a multiple of the ATR. The most popular multiple is 2, which means that your trailing stop loss should be placed at a distance of 2 x ATR. So 2 x an ATR of 0.0025, for example, would tell you to set your trailing stop loss at 0.0050.
The trailing stop-loss can protect you from major losses if the trade goes against you and or it can ensure you secure some of your profits in case the trade moves in your preferred direction.
How To Make Trading Decisions Using The ATR
Although the ATR fluctuates throughout the trading day, keeping track of it it can help a trader to approximate how far the price of a currency pair will move and how long it is going to take. For example, if the ATR on a 5-minute currency chart is 0.0010, then it is likely that the pair will rise or fall by 0.0060 pips in 30 minutes. This information can be extremely useful to a trader.
A trader can use different time periods with the ATR indicator. J. Wilder, its creator, recommended that traders use either the 7-day or 14-day periods to get the optimal results with the indicator for both long and short term trading. You should always monitor the direction of the ATR on the daily charts regardless of whether you prefer to trade the shorter time-frames (though you will also .
Analyzing Volatility In Uptrends And Downtrends
Volatility is generally low and decreasing whenever the price of a currency pair is in a dominant uptrend. The opposite is generally true of volatility in dominant downtrends as it is usually high and rising in situations where prices are falling.
By combining the ATR indicator with a moving average, you can clearly identify areas where volatility declined when prices crossed above the MA line and started rising. Whenever currency prices cross below the MA line and head lower, the volatility as tracked by the ATR also tends do increase significantly.
The ATR indicator biggest disadvantage is that it does not measure the direction of the price action in a currency pair and as such cannot provide reliable trade signals. However, the ATR is very useful in approximating the distance by which a currency pair might move, which helps traders in determining their position sizes and in their stop-loss order placement.