Average True Range Strategy
The Average True Range Strategy or ATR, as the name suggests is a trading indicator which is used to gauge market volatility. It is a trading oscillator which depicts the strength of the price action and works on the same principles as other volatility indicators such as the Bollinger Bands. When trading with volatility indicators, the basic principle to bear in mind that volatility often precedes price action. Meaning that when the volatility indicator, in this case, the ATR spikes, it signals a potential strong move (in either direction) and when volatility falls, prices tend to remain flat or trade sideways. The Average True Range oscillator is used in different ways as outlined in this article.
The Average True Range Strategy
The Average True Range comes with a default setting of 14 periods, but traders can switch to their preferred look back period. The most commonly used alternative ATR settings include 7 or 20, but of course, traders are encouraged to experiment with the ATR settings to find their ‘sweet spot’. Another factor to remember is that the ATR settings can differ based on the instrument being traded. For example, most major currency crosses tend to have the same pattern of normal volatility, where as minor crosses such as AUDCAD, GBPAUD, EURNZD and so on are more volatile and therefore the settings need to be adjusted to iron out the sensitivity. There are two main ways to make use of the ATR.
Average True Range Strategy: Entries and Exits
One of the more common and simpler ways to trade with the Average True Range is to use the indicator’s values to set entry and more importantly, exit (take profit and stop loss orders). The general trading rule is to set the stop loss two times the ATR’s value and/or the take profit level two or three times the ATR’s value depending on the other trading indicators being used. The chart below shows a simple entry where the TP and SL are set based on 2 times and 1 time the ATR value.
Average True Range Strategy
Using the Average True Range Strategy as a Breakout Strategy
The Average True Range can also be used in various trading systems. The versatility of this trading indicator makes it as easy fit into most trading systems. However, the ATR adds a lot of value with a trading strategy that works best for trading the break outs. A unique method however is using the ATR as a divergence trading tool on a 15 minute chart. The ATR tends to show some exceptional set ups when used this way and the overall basics of the divergence set ups works on the same way as any divergence based trading system. Click here to read more on divergence.
In the following chart, we notice price trading in a steady downtrend, marked the falling trend line connecting the lower highs. While price continued to fall steadily, the ATR kept up with a steady uptrend, rising gradually. When price eventually made a low, the ATR made a higher low, against the previous price action’s higher low and the ATR’s lower low.
Average True Range Divergence
Based on this divergence set up, we than take a long position on break of the trend line with the stops set to the recent low and the trade set up resulted in price reaching the specified profit level.
The Advantages of The Average True Range Strategy
There are quite a few advantages of using the ATR. One of the biggest advantages being that the indicator can be used with any existing trading system and the ATR values can be used to place the take profit and stop loss levels. These price levels are clear as they take into consideration the currency range or volatility of the markets and therefore offer more objective price levels. The ATR can also be used as part of a main trading strategy, outline in the second example, where we look at the highs and the lows formed by the ATR and compare it to the high and the low in prices. As one can see, the ATR indicator allows for a lot of scope for traders to design their own trading systems where volatility makes up for a key part of the trading system.
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