What is ATR indicator?
The Average True Range (ATR) indicator constitutes an effective tool to estimate the volatility of the price of a financial instrument at a specific time span. Volatility is very important for a day trading strategy, in order to be selected the right entry point, stop loss placement and take profit target.
ATR indicator is included in every trading software and is calculated automatically. In order the ATR to be defined, for a certain number of periods, must be calculated and selected the greatest number of the following calculations:
1: Current High less the current Low
2: Current High less the previous Close
3: Current Low less the previous Close
In this way we are taking into account the possibility of a gap in the price.
How to use ATR in a day trading strategy
The sole purpose of the ATR indicator is to measure the volatility. A profitable day trading strategy should account for high and low volatility conditions and adapt accordingly. Position management is critical and can make the difference between a winning and losing trading strategy.
In case of increased volatility we get an increased ATR value and vice versa. Position management is logical to be based on ATR value. The stop loss and take profit placement is wide in case of an increased ATR value and narrow in case of a decreased ATR value.
Time frame selection is very important when we are using the Average True Range indicator in our trading strategy. It is necessary all the estimations to be made based on a specific time frame. We cannot compare the ATR values of the 15 minutes time frame to the 4 hours’ time frame. You should stick to a single time frame while you are using the ATR reading in order to set entry point, stop loss point and take profit target.
Convert ATR value in Pips
ATR value can be expressed in pips. For example, if the value of the ATR (14) is 0.00275, this means that the maximum difference between highs and lows for the last 14 time periods or bars was 27.5 pips. If the ATR reading was 0.0009 then the difference would be 9 pips, indicating a less volatile price action. The default setting is based on the last 14 time periods or bars but this can be changed according to your day trading strategy.
How to set stop loss and take profit targets using ATR
A common way to use Average True Range indicator in stop loss placement is to set the distance between the entry price and the stop loss value to be two times the ATR value. And a common way to use ATR indicator in take profit target placement is to set the distance between the entry price and the stop loss value to be equal to three times the ATR value.
The traders are used to set the stop loss and take profit targets as multiplies of the ATR value. In this way you can be more aggressive or conservative and you can apply your own rules in your trading strategy. For example a more aggressive stop loss could be set to be equal to the ATR value. It is not recommended to set the stop loss at less than equal to the ATR value away from the entry point of the trade.
A diminishing volatility maybe is a signal to exit the trade or to put a tighter stop loss point and vice versa. The optimum volatility ratio differs between different trading strategies. But whether it is a forex pair or other financial instrument, the logic is the same. In case of a day trading strategy, the increased market noise should be taken into account and the ATR values should be used accordingly to accommodate the specific strategy.
How to define the entry point of a trade using ATR indicator
In order to define the best time to enter the market it is always wise to take into consideration the main trend along with the volatility. Average True Range value is the tool in order to gauge the volatility in a specific market. In day trading the volatility is normally increased and the strategy must be adjusted.
As a general rule, when the price action is diminished, it is not the right time to enter the market. A prolonged decrease of volatility sometimes is expressed with low ATR values and signals a possible change in the trend. The exhaustion of the interest of sellers or buyers is the reason of a reduced volatility. And under these circumstances it is better to consider more exiting the market than entering the market.
In case of an increasing volatility and if there is confirmation from the price action, entering the market is highly recommended and the most early we place a new order the better. The best time to define the entry point of a new trade, is when we have a confirmed and prevailing new trend in the market, along with an increasing ATR value.
A stable ATR value in a specific time span, along with a steady and strong trend that is apparent in price action, implies an established market and constitute a right time to enter this market. This conclusion remains valid even in case of low but steady ATR readings. The price action to confirm the initiation of a new trade could be for example an upward or downward price channel.
It is a good practice to open a new trade during a pullback of the price, in order to maximize your earnings potential. But pullback can become tricky, especially in short term trading. A good idea is to define a pullback close to one ATR away from the current price. Going away from this level the pullback may be proven a major shift of the market´s direction.
Also if a spike or another strong price action coincides with a corresponding ATR value behaviour at a certain time, this is a strong signal for the immediate price action that will follow. Maybe this is the time that a strong trend comes to an end and the market is going to consolidate or to shift direction and form an opposite trend. Under these circumstances you may spot an entry point for a new profitable trade. But also this maybe a signal to close an open trade and get out of this market.
ATR channels can be plotted on a chart, when ATR is multiplied by one, two and three times, and drawn above and below the current price. Traders are setting entry points, stop loss points and take profit targets in accordance to these channels. These channels are very effective in day trading strategies.
When the price breaches the level of three ATRs away, we are speaking about an extreme move and a pullback is possible to happen soon. This means that the trader should consider getting out of the market and close an open trade. This is an effective mean of position management in trading.
Average True Range indicator can be very useful especially when it comes to evaluate a possible entry point or the right time to exit of the market. In order to set the right stop loss point or take profit target, using solely this indicator, is not recommended and there are some pitfalls. For example you may lose an opportunity for bigger profits setting a tight take profit target.
There is no technical indicator sufficient enough in order to support by itself a trading strategy. But ATR combined with Price Action is a very effective combination and capable to increase your profitable trades. A good understanding of this tool is important and in this case it is highly recommended to incorporate ATR in your trading strategy.
Of course the average ATR level matters and is different in every market and in different time periods and circumstances. The same goes for the volatility ratio. There are no overbought or oversold levels suggested by this indicator and studding a specific market in order to make conclusions is needed. You should make your own due diligence in order to customize and optimize your day trading strategy according to Average True Range technical indicator readings.