Rather than using your own judgment, some statistical measures of price volatility are available. One of the most popular is the Average True Range (ATR) indicator, which measures the average movement for a given currency pair (or stock, commodity, etc.) for a given time period.
The ATR indicator moves up and down as price moves in an asset become larger or smaller. The indicator is based on price moves, so the reading is a dollar amount. For example, in stock trading, an ATR reading of 0.23 means that the price moves $0.23, on average, each price bar. In forex, the indicator will show pips, where a reading of 0.0025 means 25 pips.
A new ATR reading is calculated as each time period passes. On a one-minute chart, a new ATR reading is calculated each minute. On a daily chart, a new ATR is calculated each day. All these readings are plotted to form a continuous line, so traders can see how volatility has changed over time.
Because the ATR is based on how much each asset moves, the reading for one asset isn't compared to other assets in isolation. To understand the indicator better, here is how it is calculated.
Finding the A, or the average first requires finding the True Range (TR).
The TR is the greatest of the following:
Whether the number is positive or negative doesn't matter. The highest absolute value is used in the calculation.
The values are recorded each day, and then an average is taken. If the ATR is averaged over 14 time periods, then the formula is as follows:
ATR = [(Prior ATR x 13) + Current TR] / 14
Continue reading about ATR or start playing around in a risk-free demo account and notice how ATR indicator works in real time.
Typically, the default setting is 14 periods, that is, 14 days on a daily chart, 14 hours on an hourly chart, and so forth, but over time you may want to experiment with that setting. Knowing the ATR for a given period, traders can choose to place stops a given percentage of that range away from the entry point. For example, traders with great confidence in the direction of the trend who want to avoid having their stop loss hit would place their stop loss 80 to 100 percent of the ATR beyond their entry point near strong support. They’ll accept the larger loss if that stop is hit because they believe the likelihood of that happening is low. Those with less confidence and more risk aversion who want smaller losses (even if there are more of them because the stop gets hit) might place their stop closer, perhaps 50 percent or less of the ATR away from the entry point. Once you know the average volatility for a given period via the ATR, you have a better idea of how far away your fixed or trailing stop-loss order needs to be to avoid getting hit by random price movements.
Let's see an example of how to use ATR to gauge volatility and place a fixed or Trailing Stop Loss order.
We refer to the above example. In Figure below, we show the same EURUSD daily chart showing the daily candle for the entry date of the trade on August 11, but this time we include an ATR, which shows that over the past 14 days or daily candles, the average price range was about 210 pips. Those interested in how ATR is calculated can look it up online.
In this example, we based our stop losses on the other factors mentioned previously. However, if we wanted to lower the chances of getting stopped out of the trade-in exchange for the risk of more loss if the trade turned against us, we could have set the stop loss at a distance 50 percent or more of the ATR, 105 pips, beneath the entry point, or some different percentage of ATR.
The point here is that there are different ways to determine how far away you set your stop loss. In this forex trading example, we used the recent lows as a guide though we could have used ATR instead. Much depends on factors like your risk appetite, market conditions, and confidence in the trade. For example, if you’ve caught a pullback to strong support in an overall strong uptrend, you might have more confidence that this uptrend will resume and allow a wider stop loss to avoid getting stopped out by random price movements. When you’re less confident, you might keep stops tighter.
This section shows you how to set up the ATR indicator in MT5. It assumes that you have opened a chart.
Add an ATR indicator and set the parameters of this indicator:
Setting the common parameters
After you have completed the step above, the settings menu appears.
Most indicators can be controlled by several common parameters.
There are two types of parameters:
Changing parameters at a later time
To change the settings of the indicator directly on the chart at a later date:
The parameter menu appears again where you can change the indicator.
Deleting an indicator
To delete the ATR indicator:
The ATR indicator disappears from your chart.
ATR is not a directional indicator like MACD or RSI, but rather a unique volatility indicator that reflects the degree of interest or disinterest in a move. Strong moves, in either direction, are often accompanied by large ranges, or large True Ranges. This is especially true at the beginning of a move. Uninspiring moves can be accompanied by relatively narrow ranges. As such, ATR can be used to validate the enthusiasm behind a move or breakout. A bullish reversal with an increase in ATR would show strong buying pressure and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break.
Understanding how to read ATR indicator is important, but if you want some help, MetaTrader 5 AM Broker offers a useful Indicator toolkit and our trainers can provide you the right guidance. Play around in a demo forex and notice how ATR indicator can make you serious money.