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Volatility is one of the most important metrics for traders to master since it reflects the amount of fluctuation or dispersion in an asset's price. Among the popular indicators for measuring volatility is the Average True Range (ATR).

This guide will provide an overview of ATR, how it works, and how it compares to other common volatility metrics like standard deviation, Bollinger Bands, and Keltner Channels.

 

Specifying the Average True Range (ATR)

ATR is an indicator that measures volatility in terms of a security's price range over a given period. For daily data, it is typically measured on a 14-period timeframe.

The "true range" refers to the greatest of the following:

  • Current high minus the current low
  • Current high minus the previous close (absolute value)
  • Current low minus the previous close (absolute value)

This true range captures the full scope of a stock's volatility. The ATR then takes a simple moving average (SMA) of the true ranges over the last 14 periods.

The result is a smooth volatility metric that helps gauge the degree of price movement. ATR will increase when volatility is high and decrease when volatility is low.

 

Comparing ATR to Standard Deviation

 

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Standard deviation is a statistical measure of dispersion from the average. It measures how tightly or loosely clustered the price bars are over a period of time.

It is calculated as the square root of variance, which measures the average distance between each price bar and the mean price.

So, a higher standard deviation indicates that price action is more spread out from the average - reflecting higher volatility. The major drawbacks of standard deviation are that it is more abstract and more complex to interpret than ATR.

 

ATR has a couple of advantages over standard deviation:

  • Easier interpretation - ATR uses absolute dollar values rather than an abstract statistical concept. Based on past values, Traders can see if ATR is high or low.
  • Focus on true range - Standard deviation uses the closing prices in its calculation. But ATR focuses on the true high-low range, which provides a better sense of volatility. Closing prices alone may not reflect the intraday volatility.

ATR will likely be more useful for most traders than the standard deviation. ATR provides an intuitive sense of volatility, while standard deviation is more conceptual.

 

You might also like to read: Vortex Indicator vs Standard Trend Indicators

 

ATR's Difference Towards Keltner Channels

Keltner Channels are volatility bands developed by Chester Keltner in the 1960s. They are quite similar to Bollinger Bands, with two differences:

  • The middle line uses a 10-period EMA rather than SMA
  • The bands use ATR rather than the standard deviation

Since Keltner Channels use ATR to measure bandwidth, this volatility indicator has the most similarities with ATR.

However, the directional component and band squeeze signals differ from the non-directional ATR.

Keltner Channels are useful for identifying breakouts, while ATR focuses on volatility metrics for stop losses, position sizing, etc.

 

ATR vs the Bollinger Bands

 

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Bollinger Bands are similar to ATR, as wider bands imply higher volatility. However, there are a few notable differences:

  • Directional vs. non-directional - Bollinger Bands move up and down with price, incorporating a directional component and volatility. ATR is non-directional and only focuses on volatility.
  • Price action-based - Bollinger Bands use the 20-period close in their calculation. ATR incorporates the full high-low range rather than just closing prices.
  • Band squeezes - Bollinger Bands can "squeeze" as the bands dynamically widen and contract. ATR provides smoother measurements without squeeze signals.

Overall, Bollinger Bands may be more helpful in identifying consolidations and breakouts based on band squeezes. ATR is optimal for purely measuring volatility levels.

 

Consider giving this a look: Using Bollinger Bands To Set Stop Losses And Take Profit Levels

 

How to Use ATR in Your Trading

Now that we have compared ATR to other volatility metrics let's discuss tips for applying ATR across different trading strategies and setups:

Trend Trading

Use ATR when gauging whether a trend is strong enough to trade. Higher ATR values suggest a stronger trend. Scale into trends gradually as ATR starts expanding. The widening range reflects growing momentum.

 

Focus trend trading on pairs with elevated ATR levels. Avoid choppy, low ATR markets.

Range Trading

Look for low ATR environments that reflect tight ranges and contractions. These allow clean entries and defined risks. Use ATR to help determine range support and resistance. Range height can be a multiple of ATR.

 

When ATR declines, expect ranges to persist. Rising ATR warns of impending breakouts.

Breakouts

Reference ATR when setting profit targets—for example, target 2x or 3x ATR above a breakout point. Confirm breakouts in low ATR environments for higher probability setups. Low ATR reflects compression ahead of big moves.

Pullbacks

Expect pullbacks to the ATR moving average in uptrends. The ATR MA serves as a dynamic support.

 

In downtrends, sell pullbacks that stall at the ATR moving average. It converts to resistance. The deeper the pullback relative to ATR, the more significant the support/resistance level.

Stop Losses

Use 1.5 or 2 x ATR as an initial stop loss on new trades. Adjust as the trade develops. Trail stops below prominent swing lows, but use ATR as a guide for giving trades room. If ATR is expanding, consider widening stops to avoid premature exit.

Position Sizing

Position sizes are smaller when the ATR is elevated. Higher volatility warrants less risk per trade. Look to increase position size when the ATR tightens. Lower volatility allows taking on more risk—scale position size in proportion to ATR. For example, cut size in half when ATR doubles.

 

Bottomline

The Average True Range (ATR) is an invaluable tool for measuring volatility and guiding nearly every aspect of trading.

As we've seen, ATR allows traders to gauge trend strength, identify low volatility setups, set profit targets and stop losses, and size positions appropriately.

Compared to similar indicators like standard deviation and Bollinger Bands, the ATR stands out for its intuitive interpretation and incorporation of intraday price action.

The ATR indicator provides critical insights for trend, range, breakout, and pullback strategies. Traders looking to master volatility should make ATR a staple in their charting toolbox.

 

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”

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