Trading relies heavily on volatility. Volatility means how frequently and how fast is the price of an asset increasing (or decreasing) over time. Volatility is something traders are looking to understand to be able to make smarter, and better, trading decisions. Average True Range (ATR) is one useful way of measuring volatility. In this article, we are going to look into what is ATR, how it is calculated, how traders use it, and its limitations.
What is Average True Range (ATR)?
Average True Range (ATR) is a tool that serves to measure market volatility. J. Welles Wilder Jr. invented this tool in 1978. ATR does not tell traders whether the price is going up or down, it shows how much the price is moving. By doing this, traders will be able to understand how volatile a market is during a particular time period.
In practice ATR is usually calculated over the past 14 days. However, the time frame may be changed to what the trader desires. For instance, in the cryptocurrency market where prices fluctuate rapidly, traders could take a 24hr-period if at all possible.
How ATR is Calculated
To calculate ATR, traders first find the “True Range” (TR). The True Range is the greatest of three values:
- The difference in price between the current high and low.
- The difference in price between the current high and previous closing price.
- The difference in price between the current low and previous closing price.
After calculating the True Range for each period, the average is taken. This is the Average True Range. If the ATR is high, it means the market is very volatile. If the ATR is low, the market is calm.
Why Do Traders Use ATR?
ATR is used by traders to determine how much price may change. It allows them to make better decisions. ATR can be especially helpful in volatility driven markets like cryptocurrency.
Setting stop-loss orders are one common use for ATR. A stop loss order is an order to sell an asset if its price falls to a level. ATR is something traders use to determine a reasonable distance from their opening purchase price to set the stop loss. It prevents the stop loss from being ‘hit’ too early on normal price fluctuations.
ATR in Cryptocurrency Trading
The cryptocurrency markets are very volatile. It can happen very quickly and traders need a technique to control risk. ATR is useful in this case. Traders use it to find out whether the market is a very volatile one or not.
With a high ATR, big price swings are occurring so traders may step a bit more cautiously. Low ATR means small price movements and such smaller changes can be taken advantage of by traders.
ATR is used by traders to determine whether or not to enter or exit a trade. In case that ATR is high, they may wait for a more calm period. Low ATR will make them enter in a trade to make profit from smaller changes in price.
Using ATR for Stop-Loss and Take-Profit Orders
Stop losses and take profits orders tend to be determined via ATR. These are automatic orders whereby they close a trade when the price hits a certain level. Take-profit orders help secure profit; stop-loss orders help traders from losing too much.
ATR is used by traders to set orders so they account for volatility in the market. If ATR is high, traders may desire to put their stop loss orders a little further from the entry price in order to not get stopped out too early. They can also define take profit orders based on ATR taking the market volatility into consideration and grab the profits.
Limitations of ATR
ATR is useful, but it has some limits. ATR does not tell traders what direction the price is moving; it only says the direction of the price movement. Traders only see how far the price is moving. Therefore, ATR cannot confirm whether the market is in uptrend or downtrend alone.
Second, ATR values have multiple meanings. A sudden increase in ATR does not always mean the market is reversing, for example. This may just be more volatility and, consequently, it may confuse traders.
Third, ATR indicator is based on past price movements. Traders use this to understand historical volatility not future volatility. ATR does not have any magical powers, which is why it should be used with other indicators.
Conclusion
Average True Range (ATR) is a useful means of measuring market volatility. Also, it enables traders to build risk positions and understand the flow of price fluctuations due to the nonstop risk that comes with the crypto world. However, ATR is limited to identifying price direction and future trends. ATR should not be used in isolation and it should be used with other indicators for better and wiser decision making.
