Average true range (ATR) strategy

1. 1. Average True Range (ATR) Strategy

This article details the Average True Range (ATR) indicator and how to construct trading strategies around it, specifically geared towards cryptocurrency futures trading, with relevance to binary options as well. It is aimed at beginners, providing a comprehensive understanding from the indicator's calculation to practical application.

What is the Average True Range (ATR)?

The Average True Range (ATR) is a technical analysis indicator that measures market volatility. It was introduced by J. Welles Wilder Jr. in his 1978 book, *New Concepts in Technical Trading Systems*. Unlike indicators that focus on price direction, ATR focuses solely on the degree of price fluctuation over a given period. It *does not* indicate price direction; it simply quantifies the size of price movements.

Understanding volatility is crucial for any trader. Higher volatility means larger price swings, presenting both opportunities for greater profits and increased risk of losses. ATR helps traders gauge these potential swings and adjust their risk management accordingly. It's particularly useful in the cryptocurrency market due to its inherent volatility.

How is ATR Calculated?

The ATR is calculated in three steps:

1. **True Range (TR):** This is the greatest of the following:

   * Current High minus Current Low
   * Absolute value of (Current High minus Previous Close)
   * Absolute value of (Current Low minus Previous Close)

2. **Initial ATR:** Typically, the first ATR value is calculated as the average of the True Range over a specific period (typically 14 periods).

3. **Subsequent ATR:** After the initial ATR is calculated, subsequent values are calculated using the following formula:

  ATR = [(Previous ATR * (n - 1)) + Current TR] / n

  Where:
  * n = the time period (e.g., 14)
  * ATR = Average True Range
  * TR = True Range

While the calculation seems complex, most trading platforms automatically calculate and display the ATR. You can find it within the indicators section of your charting software.

Interpreting the ATR

A higher ATR value indicates higher volatility, meaning larger price swings. A lower ATR value indicates lower volatility, suggesting smaller price movements. There isn't a universal "high" or "low" ATR value, as it's relative to the asset and the timeframe being analyzed.

• **Increasing ATR:** Suggests that volatility is increasing, potentially signaling the start of a new trend or a breakout.
• **Decreasing ATR:** Suggests that volatility is decreasing, potentially indicating a consolidation phase or the end of a trend.
• **High ATR followed by a sharp decrease:** Can signal a potential trend reversal, as the rapid loss of momentum can indicate exhaustion.
• **Low ATR followed by a sharp increase:** Can signal a potential breakout, as the sudden surge in volatility can indicate a strong move in price.

It's important to compare the current ATR value to its historical values to get a better understanding of its significance. For example, an ATR of 50 might be considered high for a stock but low for a highly volatile cryptocurrency like Bitcoin. Analyzing ATR in conjunction with other technical indicators is crucial.

ATR Trading Strategies

Here are several trading strategies based on the ATR indicator:

• **ATR Trailing Stop Loss:** This is arguably the most popular application of ATR. A trailing stop loss automatically adjusts as the price moves in your favor, locking in profits while still allowing the trade to continue if the trend persists. The stop loss is set a multiple of the ATR below (for long positions) or above (for short positions) the current price.

  *Example:* If the current price is 100 and the ATR is 5, a trailing stop loss could be set at 95 (100 - (5 * 2)).  As the price rises, the stop loss moves up proportionally, maintaining a distance of two ATRs.

  This strategy helps protect profits and limit losses, particularly in volatile markets.  The multiple of the ATR used to set the stop loss determines the sensitivity of the stop loss – a higher multiple means a wider stop loss and less chance of being stopped out prematurely, but also a larger potential loss.

• **ATR Breakout Strategy:** This strategy looks for breakouts from consolidation ranges. When the price breaks above or below a recent high or low, and the ATR is increasing, it can signal a strong breakout with potential for significant price movement.

  *Example:* If the price breaks above a 20-period high, and the ATR has been steadily increasing over the past few days, a trader might enter a long position, anticipating further upside.

  Confirmation with volume analysis is essential for this strategy.  A breakout accompanied by high volume is more likely to be genuine than a breakout with low volume.

• **ATR Volatility Expansion Strategy:** This strategy identifies periods of increasing volatility and attempts to capitalize on the resulting price swings. It involves looking for ATR to expand after a period of consolidation.

  *Example:* If the ATR has been relatively flat for several days, and then suddenly starts to increase, a trader might look for long or short entry points, depending on the overall trend.

  This strategy is best suited for experienced traders who can quickly adapt to changing market conditions.

• **ATR Bands:** Similar to Bollinger Bands, ATR Bands are created by plotting lines a multiple of the ATR above and below the price. These bands dynamically adjust to volatility, widening during periods of high volatility and narrowing during periods of low volatility. Trading signals are generated when the price touches or breaks these bands.

• **ATR and RSI Combination:** Combining ATR with the Relative Strength Index (RSI) can provide more robust trading signals. For example, a high ATR value combined with an oversold RSI reading might signal a buying opportunity, while a high ATR value combined with an overbought RSI reading might signal a selling opportunity.

ATR in Binary Options

While primarily used in traditional futures trading, the ATR indicator is also valuable in binary options trading. Here's how:

• **Volatility Assessment:** ATR helps determine the potential payout for a binary option contract. Higher volatility (higher ATR) generally leads to higher payouts, as the probability of the option finishing in the money is lower.
• **Expiration Time Selection:** ATR can inform the selection of the appropriate expiration time for a binary option. In highly volatile markets (high ATR), shorter expiration times are generally preferred, as the price is more likely to make a significant move in a short period. In less volatile markets (low ATR), longer expiration times might be more suitable.
• **"Touch/No Touch" Options:** ATR can be used to assess the likelihood of a price "touching" or "not touching" a certain level. Higher ATR suggests a greater probability of the price touching the level.

However, it's crucial to remember that binary options have a fixed payout structure. The ATR doesn't predict *direction* only volatility. Binary options are a zero-sum game, and relying solely on ATR can be risky.

Risk Management with ATR

ATR is a powerful tool for risk management. Here’s how:

• **Position Sizing:** ATR can help determine the appropriate position size for a trade. In highly volatile markets (high ATR), smaller position sizes are recommended to limit potential losses.
• **Stop Loss Placement:** As discussed in the trailing stop loss strategy, ATR is excellent for setting dynamic stop losses that adjust to market volatility.
• **Volatility-Adjusted Position Sizing:** A more advanced technique involves adjusting position size based on the ATR. The formula might look like this:

  Position Size = (Account Balance * Risk Percentage) / ATR

  This ensures that your risk per trade remains consistent regardless of market volatility.

Limitations of ATR

• **Lagging Indicator:** ATR is a lagging indicator, meaning it's based on past price data. It doesn't predict future price movements.
• **Doesn't Indicate Direction:** ATR only measures volatility, not price direction. It needs to be used in conjunction with other indicators to generate trading signals.
• **Susceptible to Whipsaws:** In choppy or sideways markets, ATR can generate false signals, leading to whipsaws (quick reversals).
• **Parameter Sensitivity:** The ATR’s period (typically 14) can significantly impact its sensitivity. Experimentation is needed to find the optimal period for different assets and timeframes.

Conclusion

The Average True Range (ATR) is a valuable tool for any trader looking to understand and manage market volatility. Whether you are trading cryptocurrency futures or exploring forex trading, day trading, swing trading, scalping, algorithmic trading, momentum trading, or even binary options, incorporating ATR into your trading strategy can improve your risk management and potentially increase your profitability. Remember to always combine ATR with other technical indicators and fundamental analysis, and to practice proper risk management techniques. Consider backtesting your strategies before deploying them with real capital. Furthermore, explore Ichimoku Cloud, MACD, Fibonacci retracements, Elliott Wave Theory, Moving Averages, Parabolic SAR, Stochastic Oscillator, On Balance Volume, Chaikin Money Flow, Commodity Channel Index, Donchian Channels, Keltner Channels, Pivot Points, Heiken Ashi, Renko Charts, Candlestick Patterns, and Support and Resistance for a more holistic trading approach.

Start Trading Now

Register with IQ Option (Minimum deposit $10) Open an account with Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to get: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners