What is ATR and how to use It
The Average True Range (ATR) is a popular technical analysis indicator used to measure volatility. Developed by J. Welles Wilder, a US-based technical analyst who also developed the Relative Strength Index (RSI), the role of the ATR indicator is to simply show when volatility is high and when it is low. In this blog post, we look at the structure of this indicator and the how to profit from using it.
Structure of ATR indicator
In order to start using the ATR, you first have to calculate it. As a first step, you should identify the True Range of the period on that particular chart, which simply represents the daily high minus its low. Once the True Range is defined, you calculate the average value for the period on the chart by using an Exponential Moving Average on the values.
In general, the ATR is calculated from the 14-day moving average of a series of true range indicators. The longer the moving average period is used, the lesser number of trading signals is generated.
In the formula above “TRi” represents a particular true range while “n” is the time period employed. Nowadays, almost all tools offer automatically calculated ATR values, so your job is to add the indicator to the chart.
Signals of the ATR
As outlined above, the basic function of the ATR is to measure volatility of the particular financial instrument. In the photo below, we see a BTC/USD chart where the ATR suddenly bursts higher. You will see that this sudden increase in volatility overlaps with Bitcoin moving higher on the 4h chart.
The highlighted purple box shows the exact overlap. The next phase, which comes after the move higher is finished, shows a consolidation of the crypto asset in the coming days and weeks. The price action trades sideways with a slight bias to the downside. This trajectory is then translated into the ATR, which decreases as the sideway action almost always comes with the lower volatility.
Signals are generated whenever the price action surpasses, or closes below, an average ATR value for that day, the ATR reading increases/decreases. In this case, ATR issues a signal as it shows that the trend is prevailing in one direction and may continue higher or lower.
For instance, if you look at the chart above using Japanese candlesticks patterns, you see that Bitcoin created a series of long candles which easily surpass the value of the ATR. So, the indicator is signalling that a trend may be starting as the volatility is picking up.
Therefore, the ATR should be mainly used to identify trading ranges and pinpoint the limit of up or down moves. When the ATR values are lower, it means that volatility is lower and your stop loss may be a bit tighter than usual as the asset currently trades in a quiet market. The same applies for profit-taking levels. For instance, when traders say “2 ATR stop”, it practically means that the distance of their stop, compared to the entry, is two times the size of the calculated ATR.
On the other hand, many traders use the ATR to calculate an exit from a trade while others use it as an indication when deciding the size of the trade. The ATR is used in this case since it essentially measures how much a position is likely to move in percentage terms on an average day.
Always use more than one crypto trading signal or indicator
When it comes to limitations, they are the same as for the vast majority of other technical indicators. You need to always cross-check readings of the ATR with other trading indicators (like CCI, Cup & Handle, Elliot Wave, Head and Shoulders) since its value can be subjective.
There is not one technical indicator that will tell you when exactly the price will reach a certain level or reverse, otherwise trading would be easy.
The second limitation is that the ATR measures only the volatility. For this reason, the ATR may generate mixed signals, which may support or not support the prevailing trend. The increase in volatility may mean two things: 1) a trend is starting to form or 2) a reverse is about to take place.
Using ATR for crypto trading
- ATR is a popular technical analysis indicator used to measure the volatility,
- It is calculated from the 14-day moving average.
- Mainly used to set stop-loss and profit-taking levels as well as to determine the size of the trade.
- Best way to use it is to combine it with other indicators to get a clearer picture about the price action and prevailing trends.