Introduction
The Average True Range indicator will not give you any indication as to the current direction of a trend, and certainly won’t tell you whether you should be going long or short, but it is still one that every forex trader should consider using.
That’s because it is one of the most useful volatility indicators that you can use. By using this indicator with a few others, it will help you determine when you should (and should not) be trading and where you should place your stop loss and price targets, and will help you find some profitable trading opportunities.
Let me expand on these points further by listing the four main benefits of using this ATR indicator.
Identify Market Volatility of Any Forex Pair
If you have read some of my previous blog posts, you will know that I regularly list the average daily trading range of all of the major currency pairs to help identify which pairs are worth trading at the present time, and I gather this data by adding the ATR indicator and taking the current ATR reading of each pair.
Ideally you want to be trading those pairs that have large daily trading ranges because these will have greater price moves, and will therefore enable you to generate more profits.
Find Intraday Trading Opportunities
Expanding on the previous point, you can also use this ATR data to find profitable trading opportunities.
For example, if the GBP/USD pair generally moves 100 points per day based on the latest ATR reading, and it has only moved 20 points in the overnight session prior to the London market opening, you know that the pair could potentially move 80 points once it breaks out of this narrow trading range.
However if the price has already traded in a range of 100 points in the overnight session, it is probably not worth trading any subsequent breakouts because the price moves may be more contained.
Therefore the ATR indicator is useful for finding good trading opportunities, and for determining how far the price could potentially move and where you should think about placing your price target if you do open a position.
Use to Determine Stop Losses and Exit Points
Another way you can use this indicator to determine where you should aim to close a winning trade is to simply use a multiple of the ATR.
So if the ATR reading is 100 points, as in the previous example, and you are taking a slightly longer term trade, you might want to consider closing your position once it moves 1 x ATR, ie 100 points, or 2 x ATR, ie 200 points, in your favor.
Similarly, you could use 1 x ATR or 2 x ATR as your trailing stop loss to help contain your losses should a position move against you, and protect your profits when the price moves in your favor.
Trade Volatility Breakouts
One final way you can benefit from using the average true range indicator is to pay attention when a pair is trading in a sideways trading range, and consider opening a position when the price breaks out with increased volatility.
In other words when the ATR reading is consistently low for a long period, but suddenly rises sharply from a low base, and other indicators are confirming a new breakout, it could be worth entering a position and trading this breakout.
Best ATR Settings for Forex Pairs
If you are planning on using the ATR indicator to help you trade the forex markets, you can experiment with different settings to help you find the best one for you. For example, you may find that a 5 or 10-period ATR setting is more than adequate if you are just interested in gauging the volatility from the last 5 or 10 days (or periods).
However, I personally like to stick to the default setting of 14 because this tends to give a good indication of volatility for all time frames. You don’t really want to be using an ATR setting greater than this because it is largely irrelevant how volatile the markets have been in the past. You just want to know how much the markets are moving (and are likely to move) right now in the present to be able to gather any meaningful data from this indicator.
Final Thoughts
The ATR indicator is a very simple indicator to use, but it is still a really good measure of volatility because a low reading will generally indicate a narrow trading range that is difficult to trade, and a high reading will indicate that the pair is very volatile right now with larger price moves.
Furthermore, although it cannot tell you whether you should be entering a long or short position, it will still help you to increase your profits by identifying profitable trading opportunities and helping you plot your exit points and stop losses. So this is an indicator that many traders could definitely benefit from.
Indeed in the video below, one professional prop trader explains why he believes that the ATR indicator is the single best indicator that every forex trader should use:
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