What is the Average True Range?

- ATR is a popular indicator of technical analysis for assessing market volatility over a given period.
- J. Welles Wilder Jr developed ATR in 1978 as a tool to determine volatility in his book titled "New Concepts in Technical Trading Systems."
- ATR can estimate price volatility across different true ranges over 14 days to determine an average.
- While ATR has many advantages, including assisting traders in determining stop-loss prices, you must analyze it with a trading strategy for a better outcome from the indicator.

Keywords: Average True Range, Market Volatility, Technical Analysis, Trading, Stop-loss


Introduction

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The crypto market is highly volatile, shifting from a low-volatility region to high volatility and vice versa. Traders frequently seek to profit from and forecast these price movements. One option is technical analysis and price volatility indicators. Average True Range (ATR) is popular with traders and analysts for this purpose. Many traders find it helpful to understand and add to their technical analysis toolkit. ATR is useful in any financial market, including forex, cryptocurrency, and others. It addresses one of the most challenging aspects of trading in the financial markets, including cryptocurrency as an analysis tool. If used adequately with an appropriate trading strategy, it minimizes risk and loss while helping to maximize profit.



What is Average True Range?

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The ATR is a volatility indicator that can help traders determine which markets to trade in to maximize profits. The best part is that it is also useful as a risk management tool to determine the ideal location for your protective stop loss.

J. Welles Wilder Jr., a technical analyst, invented ATR in 1978. Since then, ATR has become one of the most well-known types of technical volatility indicators. The indicator computes the market's average price of assets over 14 days. ATR does not provide trend information or price direction but provides a snapshot of price volatility during that period.

Traders consider these low or high-price volatilities when deciding whether to buy or sell assets during the period. It's important to remember that ATR only approximates price volatility; hence, should only be used as a guideline.


How Average True Range works

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The ATR indicator assists traders in measuring volatility and determining the best market setup to maximize risk. Most cryptocurrency traders struggle with position size or stop loss. The number of units of an asset purchased or sold in a single trade is the position size. On the other hand, stop loss is an automatic order to purchase or sell a crypto asset when a specific price, also known as a stop price, is reached. ATR is more than just an indicator; it is a great tool that helps traders manage risk responsibly when using a stop loss.

Stop-loss orders can be tricky for most traders. A more comprehensive stop loss exposes traders to losing significant funds, and a tight stop loss would expose the trader to being knocked out of the market in no time. Understanding ATR as a trader gives you an edge over others in the crypto market. Your chances of being on the good side of volatility are usually on the high side.


In this case, the ATR is used with price action analysis to identify a high-probability entry. The price has reached the upper limit of the ATR, indicating that it has reached the top of the average daily range. So, the goal now is to find a technical indicator to create a short position.

The inside down bar provides the entry signal in this case, which is a high-probability entry owing to the fact that it is at the top of the daily ATR. This example shows how integrating price action with the ATR indicator can result in powerful trades.


How to calculate Average

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The first step in calculating ATR is determining the most incredible true range (TR) for a given period. This step entails calculating three distinct fields and selecting the largest of the three:
1. The most recent period's high minus the most recent period's low
2. The absolute value (ignoring any negative sign) of the most recent period's high minus the previous period's close price.
3. The absolute value of the most recent period's low minus the previous period's close price.

Depending on the trader's focus period, the period can vary. For example, in the case of cryptocurrency, the period could be 24 hours, whereas, in the case of stocks, it could be a single trading day.

When calculating the average true range over a given period (typically 14 days), the true range is calculated for each period, summed, and a simple average is calculated.



Using Average True Range as a Stop Loss

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The ATR is commonly used as a trailing stop loss system because it allows for the use of volatility as a measure to protect current market positions. It also helps hold trades for extended periods and capitalize on trending markets.

Trailing stop loss is intended to limit risk and lock in profits while not giving up too much of your profit.
Use 1.5 x ATR to determine your trailing stop loss, giving you plenty of room for stop-loss hunting. For example, at the current price of BTCUSD, $23,800, the ATR is 1000.
You will do this to set a reasonable stop-loss for either a long or short position.
LONG position stop loss = $23,800 - (1.5 x ATR)
SHORT position stop loss = $23,800 + (1.5 x ATR)


Using ATR to set a Profit Target

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The main advantage of using the ATR to set targets is that it provides information about reasonable price targets based on the underlying volatility.

The ATR indicator provides a reasonable estimate of the day's possible range. However, it would help if you had more than the ATR indicator to fine-tune your exits. Price targets should be set using the ATR indicator in conjunction with a market structure, such as support and resistance levels, previous swing high/low points, moving averages, and more.
So, if the current daily Bitcoin ATR is $200, you could set your profit target to 2 or 3 times the ATR value. That would be a profit target of $400 or $600.

Here are some best practices for using ATR to set profit targets:
1. Determine market structure, such as support and resistance.
2. Make use of more extended ATR time frames. Depending on your trading style, you could use the daily, weekly, or monthly chart.
3. Select the profit target where factors, market structure, and ATR all come together.


Limitation of Average True Range

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The ATR is a powerful indicator that can help you improve your trading performance. However, its primary limitation is that it only provides information. However, it is ineffective for obtaining precise entry signals. The indicator must always be analyzed alongside a trading technique for a better outcome from it. In other words, the ATR is always influenced by a trading strategy or system.


Conclusion

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The ATR could be a valuable tool for making the most of unstable markets in your trading arsenal. Finally, the ATR indicator's predictive nature can provide precise risk management parameters and reasonable price targets. Because volatility is a critical factor in cryptocurrency trading, it's ideal for digital crypto assets. Its strengths are in its simplicity, but keep in mind its limitations.



Author: Gate.io Observer: M. Olatunji
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