How I use it to place fundamental trades
Before looking at how I use the ATR, it may be of some use to define what the ATR is. The Average True Range (ATR) indicator is a simple tool but is very useful in measuring volatility. In very simple terms, the ATR measures the price range of a currency pair (it could also be a stock or any security) so that the higher the volatility of the currency pair the higher the ATR.
The ATR is measured as the greatest of any of the following three metrics:
- The current high minus the low.
- The value of the current high minus the previous close.
- The value of the current low minus the previous close.
Whichever is the highest of these three metrics is then represented as the average true range of the currency pair. Typically, the number is then smoothed using a 14-day moving average. Finding the average range of a currency pair has some important implications that can help make better trading decisions.
The best example is for POSITION (FUNDAMENTAL) trading. These are trades intended to be of a very long-term nature. There are some uses for the ATR as well as for my FUNDAMENTAL trade set-ups, and I will add these as well.
I have listed four ways below of how to use the ATR as a supporting indicator when placing a trade, or use it effectively when you are already in a trade.
1. How I use the ATR when placing a FUNDAMENTAL trade:
As my approach for FUNDAMENTAL trades is from of a longer-term perspective, I look at the “Monthly ATR” for the currency pairs that I am interested in trading.
The background to my trades from my existing fundamental view is that equities are going to roll over and sell off and at the same time commodity currencies are going to weaken such as AUD, NZD, and CAD.
Keeping things very simple, which is what I try to do? I am going to use my current live trades as examples.
Firstly, I look for Fibonacci levels for entries in conjunction with pivot points. Once I have those levels analyzed, I look at my currency pair establish how much I am prepared to risk in the trade and what type of lot I will use and determine what quantity I will buy or sell based on my proposed entry and stop loss levels.
As I have written, many, many times in my blogs individual currency pairs are very volatile and smaller trade sizes should be used to cope with and absorb the wild moves associated with such pairs. The ATR gives you a fantastic lead in connection with this.
Additionally, you can hedge any trades to give you another layer of protection given their longer-term nature. The potential for huge swings before your trade takes shape in the chosen direction is always there, and hedging limits both your risk and exposure. (Hedging will appear as a future discussion topic in the TRADER TOPICS section)
GBP/NZD Entry Level: 2.1090
Monthly ATR = 850
ATR Stop: 1.9340
“My Stop” placed on the trade: 1.9500
As you can see I have room to move the stop if I want to meet the ATR indicator levels, should I decide that I want to. You must realize with such huge stop loss levels in place, and an appropriate trade size should be set accordingly.
As an example, and, all my trades above are around these lot sizes: – GBP/NZD: Potential loss 850 pips. Trade size at outset 2 x micro lots (850 x $0.20) = $170.00 risk.
If I did not alter the lot size or the limit and the trade hits my limit/target of 2.1200. Trade size 2 x micro lots (1,010 x $0.20) = $202.00 reward.
Obviously, when the trade is profitable, I would add lot sizes and move/adjust my limit accordingly. I would add lots and take profits along the way to my profit target. As a minimum, I would be looking for a 2:1 ratio. They key closing your hedge trade in the opposite direction at the correct time to maximize profitability. It is not that straightforward at times. There are other uses for the ATR that are more traditional.
2. Using the ATR to trade volatility
The ATR can be utilized as a trading signal in its own right. Let’s say that you are watching a market for some days and you have noticed that volatility has dropped significantly from its historical average. Since low periods of volatility often precede explosive moves in either direction, you could wait for the ATR to increase and place a trade in the direction of the move. Crossovers can also be used. For example, placing a trade when the fast ATR (e.g. 14 periods) crosses over a slower ATR (e.g. 100 periods). This can be an effective breakout volatility strategy.
3. Using the ATR for profit targets
For day traders, knowing the average range of a currency pair is extremely useful since it allows you to estimate how much profit potential there is in the market.
For example, there is no point looking for 150 pips of profit from a trade in the GBP/USD, if the average range for that market over the last 14 days is only 80 pips. You will simply end up waiting for profits that do not come and will likely end up losing money.
A better solution is to have the 14-day ATR and use this as your profit target. In other words, after entering a trade in the GBP/USD as above, you can give yourself a profit target of around 40 pips. This is a much safer way to trade.
4. Using the ATR as a filter
The average true range is also a good indicator to use for filtering out trades. Traders typically need volatility to make any money so if you have a system that generates lots of different signals; you can filter out those currency pairs that are low in volatility by discarding those with a low ATR. Concentrating on currency pairs with the highest ATR’s mean you can trade the markets that are experiencing the most movement and therefore the most profit potential.