A true average range (ATR) measures how much an asset moves on average during a particular time frame. An indicator can be used to confirm when a trade might be a good idea and when to place a stop-loss order.

What is the Average True Range (ATR)?

J Welles Wilder Jr introduced it in his book New Concepts in Technical Trading Systems as a technical analysis indicator. It calculates market volatility by dividing the entire price range for an asset over a specified period.

This indicator refers to the absolute difference between the current high and the current low, between the current high and the previous close, and between the current low and the previous close. 

How to use ATR in trading?

ATR estimates the price movement that can occur within a certain period. A trader can use this information to take advantage of opportunities such as:

Breakouts

Traders who trade financial assets should look for breakouts. Price consolidation signals a low volatility market by the ATR printing low values. Prices always consolidate after periods of consolidation, followed by breakouts marked by high volatility. 

By timing breakouts efficiently, traders can join trends at their earliest emergence and profit from the new trend. Traders can plan how to trade breakouts resulting from a surge in ATR after a period of low or flat values.

Using a signal line

The ATR provides weak entry points in a trending market since it is only a volatility measure. This can be rectified by adding an on the ATR that acts as a signal line. A 20-period simple moving average can be added over an ATR, and cross-checks can occur. 

In uptrending markets, traders may place aggressive buy orders if the ATR exceeds the signal line. Similarly, traders may place aggressive sell orders in the market when the ATR crosses below the signal line to confirm a downward trend.

Position sizing

In financial asset trading, position sizing is crucial in risk management. In the financial markets, traders can reduce risk exposure and enhance their trading effectiveness by applying appropriate lot sizes for different financial assets. 

Lot sizes should be smaller for markets with high volatility, while larger lot sizes should be used for markets with low volatility. With assets such as the EURCHF pair, which prints lower ATR values, traders can trade smaller lots; with assets that print higher ATR values, traders can trade larger lots.

Limitations of the Average True Range (ATR)

To use the ATR indicator effectively, there are two main limitations. In the first place, ATR is an interpretation-free measurement. 

Neither an ATR value nor any other indicator can tell if a trend is about to reverse. You should always compare the ATR readings with earlier readings to see whether the trend is strong or weak.

The ATR does not measure an asset’s price direction, only its volatility. Mixed signals can result in specific situations, such as pivots or turning points. In some cases, sudden increases in ATR may cause traders to believe the trend is confirmed. The reality may be different.

How to profit from the ATR indicator?

The ATR can be used to make money in several ways. If the price moves more than 1 ATR from the previous session’s closing price, one way is to open a position. 

Price movements over 1 ATR usually indicate that volatility has changed, and the asset will continue in the same direction. Any trader can use the ATR, as it applies to every time frame from 1 minute to 1 month.

Bottom line

It plays a role in technical analysis as an indicator of market volatility. A series of true range indicators are typically averaged over 14 days to get a simple moving average.In the past, ATR has been used to analyze all types of securities in addition to commodities markets.