Measure the price movement in the forex market with the ATR

Average True Range (ATR) was developed in 1978 by J. Welles Wilder. It is used as a volatility indicator. It was primarily used in the commodity market given its volatile nature. However, now its beings used extensively in the forex trading market with a good success rate. To put it simply, ATR does not measure price direction or duration rather it just measures the price movement. Average true range introduced the concept of True Range which is the greatest of the three values mentioned below.

- Highest of the current period minus Lowest of the current period
- Highest of the current period minus Closing of the previous period
- Closing of the previous period minus Lowest of the current period

The TR will be highest of the current period minus lowest of the current period if it gives the largest number of the three equations. However if the number given by this equation is small then one of the two other equations may be used to derive TR. The last 2 equations are generally used when the highest of the current period is smaller than the lowest of the previous period which would indicate a potential gap down or the closing of the previous period is lowers than the closing of the current period, this would again indicate a potential gap. Since TR should be a positive number absolute values are applied to the difference.

Average True Range, as the name suggests is the average of the True Range (TR) over n periods. It is a simple moving average. The value if ‘n’ is usually set at 14. From the definition of TR and its calculation it’s easy to see that ATR gives the actual movement of the price over n trading periods. ATR also takes into account trading periods where price gaps existed between periods.

Since ATR is the measure of price volatility of a particular security it is based on the price of that particular security that is to say that the calculation of ATR is not normalized so one cannot compare two securities through this indicator unless the value of ATR is normalized. The ATR would be different for securities trading at different prices for example the ATR of a security trading at 90 would be higher than the ATR of a security trading at 40.

Interpreting the signals of an ATR indicator is fairly simple. If the ATR moves up, it indicates high market volatility similarly when the ATR moves down it indicates a fairly stable market. If the price bars are short it is indicative of little movement between high and low during the day the TR indicator will move low. But if the price bars increase in size it is indicative of a larger TR in which case the ATR will rise.

As a general rule traders will set the Stops at 2 to 4 times the ATR value. So the STOP for a current ATR value of 90 would be 90 multiplied by 2, and that would be equal to 180 pips. Other indications given by ATR include- conspicuously extreme levels (high or low) would indicate the start of a move. Low level ATR is indicative of small ranges while a high level of ATR indicates larger ranges. An extended period of low ATR would means consolidation or the start of a move in the same direction or a reversal. A high ATR value would be indicative of a sharp rise or decline in the price which would not usually be for a long time. Traders should know that ATR only helps in gauging the price volatility and should always be used with another technical indicator to get credible signals.

ATR indicator is primarily used to gauge the optimum position for trading stop orders because with the help of the ATR, the stops can be made to correspond with to the volatility in the market. If there is a lot of volatility in the market traders would go for a wider stop so that they don’t get stopped out due to market noise. But if there is no market volatility the STOP is not set wide since setting a tighter stop would mean better protection.