What is Average True Range (ATR)?

Introduction

Crypto trading is famous for its volatility and uncertainties. Cryptocurrencies such as Bitcoin and Ethereum have seen massive price spikes and drops — sometimes within minutes — leaving many investors scratching their heads and wondering how such volatility can happen at all. Many traders and investors worry about the price movements of cryptocurrencies when investing in crypto assets. They often seek to profit from and predict these price movements.

Traders use technical analysis tools, such as Average True Range (ATR), to understand and monitor price volatility. These indicators can help understand the market and make trading decisions. ATR analyzes a range of asset prices over a specified period, taking into consideration any gaps in the asset’s price. Before getting into the topic we need to understand what Average True Range (ATR) is all about and how to use it to maximize returns.

Understanding Average True Range

Average True Range (ATR) is a market volatility indicator that is used in technical analysis to show how much the price of an asset moves in a particular period. It is important for predicting how much an asset’s price might rise or fall in the future, and helps determine how far a stop-loss or profit objective should be placed.

J. Welles Wilder Jr., a renowned technical analyst, developed ATR in 1978 as a tool for measuring volatility. Since then, ATR has become one of the most well-known types of technical volatility indicators. ATR was designed to offer a qualitative method for putting a number on the underlying volatility of an asset. Volatility and momentum are often confused by traders. Momentum is the strength of a trend in one direction, whereas volatility is the rate at which the price fluctuates in relation to the average. As a result, more volatile markets have wider price ranges than less volatile markets.

The ATR does not show trend direction or momentum because its sole purpose is to measure volatility. Volatility indicators help traders predict when an underlying asset’s price is about to become more or less inconsistent by monitoring the level of volatility of the asset.

How Does the Average True Range Work?

ATR, like any other indicator used in the forex or stock markets, can be applied to cryptocurrency trading due to the high levels of volatility. It works remarkably well in crypto trading. In the case of Bitcoin, for example, there have been periods when the price has risen by 990% within a year and also witnessed a rapid price fall, in the same year, behaving differently from the traditional market.

The ATR indicator determines the market’s average price for assets over 14 days. Traders can use time frames of less than 14 days to create more trading signals, while longer periods are more likely to generate fewer trading signals. A low ATR indicates low price volatility, and a high ATR indicates high price volatility during the specified period. These high or low price volatilities are what traders take into account when deciding whether or not to buy or sell an asset during the period.

It is important to note that ATR is only used to measure volatility. Never use it as a buy or sell signal. This is because the ATR is intended to provide the possible range of movement for a specific period. However, it does not specify whether the range will be uptrend or downtrend. For instance, if the daily ATR is $2, the next session’s price is likely to have a daily range of $2. Therefore, it is not advisable to take a long position close to the day’s high if the price has already crossed the $2 upside mark. Considering that the price has already risen above the day’s average range, the uptrend may start to slow down.

ATR Formula and Calculation

Calculating ATR requires determining the highest True Range (TR) for a given period. To do this, three possible ranges must be computed, and the highest of the three will be selected.

• The gap between the current high and the previous close
• The gap between the current low and the previous close
• The gap between the current high and the current low

The highest value from the three methods listed above represents the True Range for the chosen period. It makes no difference whether the value is positive or negative since it is the absolute value that is considered. The average value is calculated using the values for each period, which by default consists of 14 periods. It gives the ATR value. Using the method described above, the initial 14-period ATR value is calculated. The following formula is used for subsequent 14-period ATRs:

ATR = [(Previous ATR x 13) + Current TR] / 14

The general ATR indicator formula for periods other than the recommended 14 is:

ATR = (Previous ATR x (n - 1) + TR) / n

where n is the number of periods.

The number of periods used in the ATR calculation can be changed depending on the user’s trading strategy. More trading signals will be provided by shorter time frames than by longer ones.

How to Interpret ATR Indicator?

The ATR indicator values are easy to interpret. When the ATR line drifts higher, it indicates that the underlying asset’s volatility is increasing; conversely, when the ATR line drifts lower, it indicates that the underlying asset’s volatility is decreasing. Markets fluctuate between periods of high and low volatility, and ATR assists traders in tracking these changes.

A low average true range value indicates narrow ranges over a long period. Prices are less volatile when the average true range is low. If the average true range value remains low for an extended period, this could indicate the possibility of a reversal or continuation move, as well as a consolidation zone.

The graph below illustrates how the ATR reflects low and high volatility. High volatility is illustrated by a higher ATR and a larger daily range (green area), while low volatility is illustrated by a lower ATR and a smaller daily range (pink area).

Source: Tradimo

Recommended ATR Trade Level

It is recommended that investors use the 14-period ATR as a standard for calculating trends, as this is the number commonly used as the default by most trading platforms. Welles Wilder, the inventor of the ATR indicator way back in 1978, used the 14-period ATR. This level is often considered to be a key reference by retail and institutional investors.

The ATR indicator is more sensitive when set at a lower value than 14 and produces a choppier moving average line. Setting the ATR at a higher value than 14 makes it less sensitive and produces a smoother reading. Be sure to keep this number in mind when looking at different periods, like the 4-hour, daily, weekly, and monthly.

Benefits of Average True Range

The ATR is important because it can help traders understand how volatile the market is and what kinds of trading strategies might be most successful. The benefits of using ATR include:

• Spot False Breakouts: False breakouts can be tricky to spot because they often occur when the price momentarily breaks above (or below) a key consolidation pattern, support or resistance level, previous swing high, or swing low, but then changes direction. The ATR indicator is a leading indicator that can help traders determine whether a breakout is real or not after the fact. Simply look for the following clues to identify a false breakout when using the ATR indicator:
  • The price has already reached its daily average true range or is above the range’s upper limit.
  • The breakout does not seem to be supported by an increase in the ATR.

• Trailing Stop-Loss and Avoiding Market Noise: A stop-loss is an order to sell an asset at a particular price point to limit any potential losses. The ATR can be used to set a stop-loss, as it indicates how much the price is likely to move in the future. By setting stop loss away from the daily range of price movement, the trader can avoid market noise and short-term price movements. If the price then reaches the stop-loss that was set, this means that the daily range is moving in the opposite direction to the trade, and the trader wants to cut losses short as soon as possible. Using the ATR value is then optimal for placing a stop-loss, as it allows the trader to place a stop-loss, a maximum distance away and avoid any market noise.

  Note: Market noise is any activity or information, such as short-term price fluctuations, that misrepresents or confuses genuine underlying trends in the market.

• Set Profit Target: A price point on a chart where you decide to take a profit is known as a profit target. The ATR indicator is a good tool for estimating possible price targets, but it is not the only factor to consider when setting price targets. Market structures such as support and resistance levels, previous swing highs and lows, and other moving averages also need to be considered. Simply look for the following clues to set a profit target:

  • Determine market structure, such as support and resistance
  • Use higher ATR periods or timeframes
  • Choose a profit target where market structure factors and ATR intercept

Downsides of Average True Range

While ATR offers users advantages such as price change detection and adaptability, it also has two major flaws:

• ATR is a subjective metric, which means it is open to interpretation. A single ATR value cannot predict whether or not a trend is about to reverse. Instead, ATR readings are always compared to previous readings to determine the strength or weakness of the trend.
• ATR does not account for price direction when calculating volatility. Occasionally, this can lead to conflicting signals, especially when markets or trends are at critical or tipping points. For example, some traders might mistakenly believe that a spike in ATR is a confirmation of an old trend when in reality this could be false.

ATR’s Best Indicator Combinations

The ATR only measures one price factor, volatility. Combining or pairing it with other indicators can help identify better trading opportunities in the market. The following are the top two ATR indicator pairing techniques:

• ATR and Stochastics: Stochastics is an ideal indicator for trading in ranging markets, as they provide signals indicating when prices are overbought or oversold. The ATR assists in identifying ranging markets and helps in preventing sudden price swings signals produced by Stochastics in non-ranging markets.

  Low ATR values indicate a ranging market, while Stochastics crossovers in overbought and oversold areas might indicate whether to buy or sell.

• ATR and Parabolic SAR: The Parabolic SAR indicator is best suited for trading trending markets. When combined with the ATR, traders can set definite stop-loss and take-profit price points to make sure they maximize the benefits of a trending market while minimizing risk exposure as possible.

Conclusion

ATR is a valuable tool for understanding volatility patterns in the cryptocurrency market. It is especially well-suited for digital assets, which are particularly volatile. Also, the ATR indicator is a must-have for traders who want to spot false breakouts, set profit targets, trail stop-loss, and avoid market noise.

Further, the ATR indicator is not particularly useful for generating trading signals because it merely measures the magnitude of the price range and not the direction. It is not a stand-alone indicator but can be more profitable and efficient when used in combination with other indicators. The indicators used also depend on the type of trading strategy engaged, the time horizon, the assets being traded, market conditions, etc.