In order to assess market trends objectively a day trader needs precise tools. One indicator that offers many advantages is the average true range. This day trading tool is a volatility indicator. Within any given time frame, it indicates how much, on average, a commodity futures contract, stock, or Forex pair moves. Learn how to use average true range and you will gain insight which in turn will improve your understanding of the market and, thus, your success in trading. Because commodity futures contracts are commonly more volatile than stocks, the average true range is especially useful in this trading arena.
What Does Average True Range Mean?
Average true range is a technical indicator designed to measure market volatility by breaking down the full range of prices for a commodity futures contract, Forex pair, stock, or index over a set period. Most commonly the average true range is set up over a range of 14 days. It functions as a moving average whose value is the highest of three values: current high minus current low, absolute value of the current high less the prior close, and absolute value of the current low minus the previous close.
How Does Average True Range Work?
To calculate the average true range the first thing is to determine a series of true range values. The formula may seem complicated.
TR=Max[(H − L),Abs(H − CP),Abs(L − CP)]ATR=(n1)(i=1)∑(n)TRi
TRi=A particular true range
n=The time period employed
However, day traders use software that does the calculations for them. By setting the period for average true range shorter, a day trader will get more trading signals than by setting up a longer time frame. Thus, a commodity futures day trader will generally opt for a shorter period than a swing trader interested in trading over days, weeks, or months.
How to Find the Average True Range of a Stock
The software on your trade station will do the calculations for you in finding the average true range. The indicator is displayed as a single line below your charts. It goes up with increased volatility and down with lower volatility. The average true range indicator does not help you predict where the next trend is going. It simply shows you the degree of volatility of the stock, futures contract, or Forex pair that you are trading. Day traders commonly use the average true range to help set their exit points for trades more so that determining entry points.
How to Use Average True Range for Short Term Trading
One way to use the average true range indicator in short term trading is to use it with a moving average. One can create a channel by offsetting the moving average with the current average true range both above and below the moving average. Traders who use this approach base it on the mean reversion theory. Generally, 1xATR and 1.5xATR are used to create the channels. Those who employ this approach use the outer, 1.5xATR limit as a trade exit point.
What Is Average True Range Used For?
The basic value of the average true range indicator is in measuring volatility over a given period. Across various trading scenarios the average true range indicators helps determine reasonable profit targets and where to set stop loss points commensurate with current market conditions. This is especially valuable in trading commodity futures where the market is commonly more volatile than with stocks or currencies. As with many indicators, the average true range is generally not used alone but rather in conjunction with another indicator such as a moving average.
How to Read Average True Range
When using the average true range or ATR indicator, higher ATR values indicate high volatility and lower values indicate less volatility. The indicator “looks back” over the set period. Although 14 days is the most common setting for the average true range day traders and especially commodity futures day traders will generally use a shorter period. A daily interval is the most common for day trading in markets, like commodity futures, that are more volatile than stocks or currencies.
How Is Average True Range Calculated?
The average true range uses 14 periods. These can be monthly, weekly, daily, or intraday. As an example, the average true range calculation is done for every minute on a one-minute chart and every day on daily charts. The visible result is a line that displays volatility changes over the chosen time. The value displayed is the maximum value of these three: current high minus current low, current low minus previous close, or current high minus previous close. Although these calculations can be done “by hand” they are, in fact, done by your trade station software to be available in real time.