The Average True Range (ATR) is a common technical analysis indicator designed to measure volatility. This indicator was originally developed by the famed commodity trader, developer and analyst, Welles Wilder, and it was introduced in 1978.

The ATR was intended to provide a qualitative approach that would assign a numerical figure to the underlying volatility of an asset. Many traders usually confuse volatility and momentum.

Volatility is the rate at which the price changes relative to the average, whereas momentum refers to trend strength in a particular direction. Based on this, volatile markets have wide price ranges, while less volatile markets have narrow price ranges.

The ATR is designed to purely measure volatility and the indicator neither indicates trend direction nor momentum. By tracking the degree of volatility of an asset, volatility indicators help traders to determine when an underlying asset’s price is about to become more sporadic or less sporadic. Other popular volatility indicators, other than the ATR, include Bollinger Bands and Keltner Channels.

Calculating ATR

The ATR is simply a smoothed average of an asset’s true range values. The range of an asset in any particular time period is simply the difference between the high and closing prices.

However, Welles determined that the ‘true range’ of an asset must take into account previous closing prices so that due consideration is accorded to any price gaps that may have occurred.

Based on this, the true range at any given time period is the greatest of the following:

  1. The difference between the current high and current low
  2. The difference between the current high and previous close
  3. The difference between the current low and previous close

Negative or positive true range values are not taken into consideration, with only the absolute number used in the calculation. After the first ATR is determined, the subsequent ATR values are calculated using the formula below:

Current ATR = [(Prior ATR x (n-1)) + Current TR] / n

Where ‘n’ is the user-defined number of periods

The default ‘n’ on most trading platforms is 14, but traders can adjust the number according to their needs. Obviously, a higher ‘n’ would result in a slower volatility measure, whereas a lower ‘n’ would result in a faster volatility measure.

Reading the ATR

Interpreting the ATR indicator values is simple and straightforward. When the ATR line edges higher, it implies that the volatility of the underlying asset is increasing; similarly, when the ATR line drifts lower, it implies that the volatility of the underlying asset is decreasing.

Markets oscillate between periods of high volatility and low volatility, and ATR helps traders track these changes.

Having a picture of the volatility can help traders to set definitive price targets in the market. For instance, if the EURUSD currency pair has an ATR of 100 pips over the last 14-time periods, a price target of below 100 pips is more likely to be achieved within the prevailing trading session.

How to Use ATR in Trading

The ATR is used to establish how far an asset’s price can go within a specified time period. This information can be used to trade opportunities such as:

  • Breakouts
    Breakouts represent some of the best trading opportunities when trading financial assets. When the price consolidates, the ATR will print low values to denote a low volatility market. Periods of price consolidation are always followed by breakouts, which occur with high volatility. The ATR helps traders to time these breakouts efficiently and gives them the opportunity to join the new trend from its earliest beginnings. After a period of low or flat values, a surge in the ATR will indicate higher volatility in the market and traders can plan how to trade the resulting breakout accordingly.
  • Using a Signal Line
    The ATR is only a volatility measure and in a trending market, it will not provide optimal entry points. To remedy this, traders can overlay a moving average on the ATR that will act as a signal line. For instance, traders can add a 20-period simple moving average over the ATR and watch out for crosses. When prices are trending higher, an ATR cross above the signal line will confirm an uptrend and traders could place aggressive buy orders in the market. Similarly, when prices are drifting lower, an ATR cross below the signal line will confirm a downtrend and traders could place aggressive sell orders in the market.
  • Position Sizing
    Position sizing is an important element of risk management when trading financial assets. Applying appropriate lot sizes on different financial assets can help traders to minimise risk exposure and enhance their trading effectiveness in the market significantly. As a rule of thumb, high volatility markets should be traded with smaller lot sizes, whereas low volatility markets can be traded with higher lot sizes. Assets, such as gold and Bitcoin, that have higher ATR values, traders can trade them with smaller lot sizes; while assets, such as the EURCHF pair that prints lower ATR values, can be traded with larger lot sizes.

Best ATR Indicator Combinations

The ATR measures only one price element – volatility. This fundamentally means that it is important to combine it with other indicators to identify more qualified trading opportunities in the market. Here are the best ATR indicator combinations strategies:

  • ATR and Parabolic SAR
    Parabolic SAR is ideal for trading trending markets. When combined with the ATR, traders are able to set definitive stop loss and take profit price points that will ensure they take full advantage of a trending market with minimal risk exposure as possible.
  • ATR and Stochastics
    Stochastics are ideal for trading ranging markets because they deliver overbought and oversold signals. The ATR helps qualify ranging markets and avoid whipsaw signals that can be generated by Stochastics in non-ranging markets. Low ATR values confirm ranging markets and buy/sell signals can be provided by Stochastics crossovers in overbought and oversold zones.

Using ATR for Exit Conditional Orders

No matter the quality of the entry, profit or loss is ultimately determined when a trade is exited or closed. The ATR is efficient in determining optimal price points to place stop loss and take profit orders. For instance, if the GBPUSD pair has an ATR of 150 pips, a take profit of 120 pips is much more likely to be achieved within the particular trading session compared to a take profit of 200 pips.

Similarly, a stop loss of more than 150 pips will give your trade enough breathing room to play out, without the risk of a premature loss. Because it shows rising and falling volatility levels, the ATR can also be used to place optimal trailing stops that will ensure your overall risk is minimised while giving you an opportunity to lock in profits as you ride a trend.

Limitations of the ATR Indicator

The ATR (Average True Range) indicator provides traders with insights into the degree of price volatility. However, it comes with several limitations that can affect its effectiveness in trading strategies. Below is a comprehensive list and explanation of these limitations:

  1. Does Not Indicate Price Direction –  ATR measures the degree of price volatility but does not provide any information about the direction of price movement. Traders cannot deduce from the ATR readings whether the price is trending upwards or downwards. Traders looking for signals on market entry or exit points based on price trends cannot rely solely on the ATR, as it doesn’t distinguish between bullish or bearish movements.
  2. Lagging Indicator – The ATR is calculated using historical price data, typically over a 14-period moving average. This makes it a lagging indicator that responds to past price action, which may not accurately predict future volatility spikes or drops. Thus, using the ATR can lead to delayed responses to market changes.
  3. Influence of Outliers – Sudden price movements can significantly impact the ATR calculation, especially when using a shorter period. This can lead to overestimating volatility due to one-off events, which may not reflect the ongoing market conditions.
  4. Non-Comparability Across Assets – ATR values are expressed in the same units as the asset’s price (e.g., dollars, euros). This makes them absolute rather than relative measures. Comparing ATR values between assets of different price levels becomes difficult, limiting its utility in cross-asset analysis.
  5. No Direct Buy or Sell Signals – The ATR provides insights into volatility but does not inherently generate trading signals. Traders must combine ATR with other indicators or analysis methods to make informed trading decisions. This adds to the complexity of implementing ATR strategies.
  6. Sensitivity to Period Settings – The period used in calculating the ATR (e.g. 14-day, 20-day) significantly affects its price responsiveness. Shorter periods make the ATR more sensitive to recent price changes, potentially leading to false signals. On the other hand, longer periods may smooth out important volatility shifts, leading to potential missed opportunities.
  7. Lack of Contextual Analysis –  The ATR measures volatility without considering the underlying reasons, such as economic events or market sentiment. High volatility indicated by the ATR could be due to various factors, and without context, traders may misinterpret the signals.
  8. Ineffectiveness in Low-Volume Markets –  In markets with low trading volumes, price movements can be erratic and not reflective of true market sentiment. The ATR may overstate volatility in illiquid markets, leading to misguided trading decisions.
  9. Complexity for Novice Traders –  Understanding and correctly interpreting the ATR requires a certain level of expertise in technical analysis. Beginners may find it challenging to incorporate ATR into their trading strategies effectively. This can increase the risk of misapplication of the indicator.
  10. Does Not Account for Price Gaps – While the ATR includes price gaps in its calculation, it doesn’t differentiate between gaps caused by market closures and those due to trading activity. This can distort the true measure of volatility, especially in markets that are prone to significant overnight price gaps.
  11. Static Nature –  The ATR does not adapt to changing market conditions unless manually adjusted. In highly volatile markets, a static ATR period may not capture rapid changes. This may require constant adjustments by the trader to utilise the indicator effectively.
  12. Requires Supplementary Indicators – The ATR is most effective when used in conjunction with other technical indicators. Relying solely on the ATR can result in incomplete analysis, as it doesn’t provide a holistic view of market dynamics.
  13. Potential for Misinterpretation – High ATR values might be misinterpreted as signals of market tops or bottoms. Without proper analysis, traders might make erroneous decisions based on misconstrued volatility levels.
  14. Does Not Measure Relative Volatility – The ATR provides an absolute measure of volatility but does not express it relative to the asset’s price. This makes it challenging to assess whether the volatility is significant in proportion to the asset’s overall value.

While the ATR is a valuable tool for gauging market volatility, its limitations highlight the need for cautious application. Traders should be aware of these constraints and consider integrating the ATR with other analytical tools and market insights to enhance decision-making. Understanding the context behind volatility changes and not relying solely on the ATR can mitigate potential drawbacks associated with its use.

Do’s and Don’ts of the ATR in Trading

  1. Don’t: Set Arbitrary Stop-Losses without Considering Volatility – Placing stop-loss orders at fixed distances without factoring in current market volatility can lead to premature exits from trades due to normal price fluctuations.
    Do: Use ATR to Set Stop-Loss Levels – Incorporate ATR values to determine appropriate stop-loss distances that account for market volatility. For instance, if the ATR is 50 pips, set your stop-loss slightly beyond this range to prevent being stopped out by typical market movements.
  2. Don’t: Rely Solely on ATR for Trading Decisions – The ATR doesn’t indicate price direction. This means that basing trades only on ATR readings can result in misguided strategies that overlook important trend information.
    Do: Combine ATR with Other Indicators – Use the ATR alongside trend indicators like Moving Averages or momentum indicators like the RSI to gain a comprehensive view of the market. Such combinations help confirm signals and support more informed decision-making.
  3. Don’t: Stick to Default Settings Without Evaluation – Using the default 14-period setting without assessing its effectiveness for your specific needs may limit the indicator’s usefulness and responsiveness to your trading style.
    Do: Adjust ATR Periods to Match Your Trading Style – Modify the ATR calculation period to suit your trading timeframe. Shorter periods make ATR more responsive for day traders, while longer periods smooth out volatility for swing traders.
  4. Don’t: Ignore External Factors Influencing Volatility – Overlooking economic news releases or events that cause volatility spikes can lead to misinterpretation of ATR signals.
    Do: Consider the Impact of Market Events on ATR – Stay aware of upcoming news releases or events that may affect market volatility. This way, you can adjust your strategy accordingly when you notice significant changes in the ATR readings.
  5. Don’t: Maintain Uniform Position Sizes Regardless of Volatility – Failing to adjust position sizes in response to changing volatility can expose you to larger losses during turbulent market periods.
    Do: Use ATR for Position Sizing – Adjust your position sizes based on the ATR to manage risk effectively. Consider lowering your position sizes when the ATR indicates higher volatility to help mitigate potential losses.
  6. Don’t: Set and Forget Your ATR Configuration – Markets evolve constantly, and static ATR settings may become less effective. This can reduce the indicator’s accuracy in reflecting current market conditions.
    Do: Regularly Reassess ATR Settings – Periodically review and update your ATR parameters to ensure they align with current market conditions and your trading objectives. This will enhance the effectiveness of the ATR indicator.
  7. Don’t: Blindly Trust ATR Values During Unusual Market Activity – Ignoring abnormal price movements that can skew the ATR readings may lead to incorrect assessments of market volatility and flawed trading decisions.
    Do: Be Cautious of Outliers Affecting ATR – Identify and account for abnormal price spikes or drops that may distort the ATR. Consider using alternative calculation methods or adjusting your analysis during such periods.
  8. Don’t: Compare ATR Values of Different Assets Directly – Direct comparisons can be misleading due to differing price scales and volatility profiles of different assets.
    Do: Understand the Limitations of ATR Across Different Assets – Use percentage-based ATR or normalise the values when comparing volatility across assets with different price levels to make meaningful comparisons.
  9. Don’t: Use ATR Without Adequate Knowledge – Misunderstanding how the ATR works can result in misapplication. This can consequently lead to ineffective strategies and potential losses.
    Do: Educate Yourself on Proper ATR Interpretation – Invest time in learning about ATR functions and best practices for integration into your trading plan. You can learn more about the ATR with courses, books or reputable online resources (including the AvaAcademy).
  10. Don’t: Ignore Market Liquidity Conditions – Trading in illiquid markets without considering the limitations of the ATR can lead to unexpected outcomes. This is because the ATR may overstate volatility in low-volume or low-volatility environments.
    Do: Monitor Liquidity and Volume When Using ATR – Be cautious when trading in markets with low liquidity. Adjust your strategies to account for potential misrepresentations of volatility indicated by the ATR during such conditions.

Three Advanced ATR Strategies

ATR with Moving Averages for Trend Following and Risk Management

Strategy Overview:

Combine the ATR with Moving Averages (MAs) to identify trends and set dynamic stop-loss levels. Moving Averages help determine the direction of the trend, while ATR helps you to adjust your stop-loss orders based on market volatility.

How It Works:

  1. Identify the Trend with Moving Averages:
    • Use two Moving Averages of different periods e.g. 50-day and 200-day SMA.
    • A bullish signal occurs when the shorter period MA crosses above the longer MA.
    • A bearish signal occurs when the shorter period MA crosses below the longer MA.
  2. Enter the Trade:
    • Go long when a bullish crossover happens.
    • Go short when a bearish crossover occurs.
  3. Use ATR for Stop-Loss Placement:
    • Calculate the current ATR value.
    • Set your stop-loss below the entry price minus a multiple of the ATR for long positions e.g. Entry Price – (1.5 × ATR).
    • Set your stop-loss above the entry price plus a multiple of the ATR for short positions.

Benefits:

  • Dynamic Risk Management – ATR-based stop-loss placement adjusts to market volatility. This reduces the chance of premature stop-outs during periods of high volatility.
  • Trend Confirmation – Moving Averages help confirm the trend direction, improving entry timing.

Example: If you’re trading a stock currently priced at $100, with an ATR of $2:

  • For a long position, set a stop-loss at $100 – (1.5 × $2) = $97.
  • For a short position, set a stop-loss at $100 + (1.5 × $2) = $103.

ATR with Relative Strength Index (RSI) for Enhanced Entry and Exit Points

Strategy Overview:

Use the ATR to gauge market volatility while employing the RSI to identify overbought or oversold conditions. This combination helps refine entry and exit points by accounting for both momentum and volatility.

How It Works:

  1. Identify Overbought/Oversold Conditions with RSI:
    • RSI values above 70 indicate overbought conditions (potential sell signal).
    • RSI values below 30 indicate oversold conditions (potential buy signal).
  2. Assess Volatility with ATR:
    • Observe the ATR value to understand current market volatility.
    • A higher  ATR suggests higher volatility, which may affect the timing of your trade.
  3. Combine Signals for Trade Execution:
    • Entry Point:
      • Enter a long position when the RSI is below 30 (oversold) and the ATR shows decreasing volatility. This indicates upward price movement is losing momentum, and a possible reversal is on the cards.
      • Enter a short position when the RSI is above 70 (overbought) and the ATR shows decreasing volatility.
    • Exit Point:
      • Use the ATR to set stop-loss and take-profit levels, adjusting for current volatility.

Benefits:

      • Improved Timing – Combining the RSI with the ATR helps filter out false signals during periods of high volatility.
      • Risk Adjustment – The ATR allows you to adjust position sizes and stop-loss levels according to market conditions.

Example:

      • If the RSI drops to 25 and the ATR is decreasing, it may signal a good opportunity to enter a long position with a tighter stop-loss based on the lower ATR value.

ATR with Bollinger Bands for Breakout Trading

Strategy Overview:

Integrate the ATR with Bollinger Bands to identify and confirm potential breakouts. Bollinger Bands indicate volatility and price levels, while the ATR measures the strength of the volatility expansion associated with breakouts.

How It Works:

      1. Set Up Bollinger Bands:
        • Apply Bollinger Bands to your price chart, typically 20-period SMA with bands set at 2 standard deviations.
      2. Identify Squeeze and Breakout:
        • A “squeeze” occurs when the Bollinger Bands narrow, indicating low volatility and potential for a breakout.
        • A breakout is signalled when the price moves outside the upper or lower band.
      3. Confirm with ATR:
        • Observe the ATR value at the point of breakout.
        • An increasing ATR during a breakout confirms that volatility is rising, supporting the likelihood of a sustained move.
      4. Execute the Trade:
        • Enter a long position if the price breaks above the upper band and the ATR is increasing.
        • Enter a short position if the price breaks below the lower band and the ATR increases .
      5. Set Stop-Loss and Take-Profit Levels:
        • Use the ATR to set stop-loss orders beyond typical price fluctuations e.g. Stop-Loss = Entry Price – (1 × ATR).
        • Determine take-profit levels based on risk-reward ratios or key support/resistance levels.

Benefits:

      • Volatility Confirmation – The ATR helps confirm whether a breakout is significant or likely to fail.
      • Dynamic Risk Management – Adjusting stop-loss levels with the ATR accounts for the increased volatility during breakouts.

Example:

    • If a currency pair breaks above the upper Bollinger Band with an ATR spike from 0.0010 to 0.0015:
      • The increasing ATR supports the breakout’s validity.
      • Enter a long position with a stop-loss set at Entry Price – (1 × 0.0015).

      General Tips for All Strategies

      • Backtesting – Always backtest your strategy on historical data to assess its effectiveness before applying it in live trading.
      • Risk Management – Use the ATR to adjust position sizes to keep your risk consistent across trades in different volatility periods.
      • Stay Informed – Be aware of major economic news releases or events that can cause sudden changes in volatility, affecting ATR readings and trade outcomes.

      Combining the ATR with other technical indicators, like Moving Averages, RSI, and Bollinger Bands, can provide a more nuanced view of the market. ATR adds the volatility dimension to your analysis, allowing for better risk management and more informed trading decisions. Remember that no strategy guarantees success, therefore, it’s essential to use these tools as part of a comprehensive trading plan that includes proper risk management and continual learning.

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      Main ATR Indicator And Strategies FAQ

      • What is the ATR Indicator?

        The ATR Indicator, or Average True Range indicator, is an indicator that measures volatility. As such it is not a trend following indicator. It is possible for volatility to be either low or high during any trend. What the ATR is really good at is identifying potential explosive breakout moves. As a measure of volatility the ATR is also used by traders to set a trailing stop loss on their trades. This accounts for the volatility in any given market and avoids getting stopped out too quickly.

      • How to profit from the ATR Indicator?

        There are several ways to profit from using the ATR. One simple method is to open a position whenever price moves more than 1 ATR from the closing price in the prior session. This works because typically when price moves more than 1 ATR it is because there has been a change in volatility, and generally the asset will follow through with a continued move in the same direction. The ATR can be used on any time frame too, from 1 minute to 1 month, making it useful for any type of trader.

      • How can we find breakout moves using the ATR Indicator?

        Because ATR measures volatility it can be very useful in locating breakout moves just as they are beginning, and doing so is quite easy. First look for a weekly chart where the ATR and volatility is at multi-year lows. Next identify the range in price during this period, or the strongest support and resistance levels. Wait for price to break out from the range or from the support/resistance level and pounce on the trade.

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      ** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.