Volatility is considered to be the key feature of a crypto trade market. The fluctuations in the market are usually difficult to be predicted by traders. However, they are always keen to take the full benefit of these movements in the prices of assets in the market.
Traders use different indicators and technical tools to predict such situations. Average True Range (ATR) is one such price indicator.
ATR has multiple advantages that help the traders in different ways, such as an aid for the traders, determining stop loss prices, etc. However, there are certain limitations attached to it too.
Here is a comprehensive article that will help the readers about the working of average true range, its pros and cons, and how it helps traders in predicting market conditions.
Introduction to Average True Range (ATR)
Average True Range (ATR) is one of the most commonly known indicators that help traders to predict market volatility beforehand. In year 1978, J. Welles Wilder Jr., a technical analyst, created Average True Range (ATR) that could be used as a normal technical tool in the market.
ATR can be used to calculate and determine the approximate price volatility in order to determine an average across different ranges during a 14-day period.
In addition to that, it has also become an important part of other technical tools that are used to calculate market movements. These tools include the Average Directional Movement Index Rating (ADXR) and Average Directional Movement Index (ADX).
The price direction or the trend of the information is not predicted by the Average True Range (ATR), but it provides a view of price volatility during the period of 14 days.
The value of the Average True Range (ATR) determined is directly proportional to the price volatility in the market. The higher the ATR, the higher the market price volatility, and lower values of ATR refer to low price volatility.
The traders actually consider the volatilities in the price of the assets if they are low or high in case they have to buy or sell any asset during the given period.
One should be aware of the fact that Average True Range (ATR) should be only used as an aid for traders as it only determines the approximate value of price volatility.
Understanding the Concept of Volatility
To understand the concept of Average True Range (ATR) properly, one needs to have a sound view of the concept of volatility. The volatility and fluctuations in the crypto market cannot be predicted accurately, but one can have an approximate idea about it.
Those who learn this concept in a better way get an edge of benefit over the other traders in the market.
It is considered a very important concept in the crypto market, but it also has applications in almost every field. Volatility needs to be calculated by risk managers and quantitative analysts to manage their position and work in the market.
Types of Volatility
The standard deviation is one of the most commonly used methods of volatility. It is considered one of the important statistical tools for finding volatility, and so is variance. The square of deviation from the mean value is called variance.
There are a number of types of volatility that can be predicted and used to acquire benefits in the market.
The volatility is considered for a certain time period. Although it has happened in the past, it is still considered an important factor in predicting volatility in the future. Standard Deviation is one of the well-known examples of historical volatility.
This is also known as local volatility. It is the volatility of the market over any certain period of time. It has no definite period of time and is hard to be calculated.
The market participants consider it as the actual volatility that could be expected in the future. When the values are inserted in the Black-Scholes equation, the market option price that comes out is known as implied volatility.
The volatility that is calculated for a defined specific period of time is known as forward volatility.
Calculating Average True Range (ATR)
The True Range (TR) has to be calculated in order to calculate the Average True Range (ATR). This refers to the calculation of different ranges three times and then choosing one among them.
Calculating the difference between the high of the latest period and the low of the latest period.
Calculating the absolute value of the difference between the high of the latest period and the close price. The negative sign is ignored while calculating the absolute value.
Again, calculating the absolute value of the difference between the low of the latest period and the close price.
There can be different periods that totally depend upon the focus period of the trader. It could be a period of 24 hours if crypto is considered or a period of a trading day if we talk about stocks.
The true range is calculated for the defined period, then it is summed up, and the simple average is taken in order to calculate the Average True Range (ATR) over that defined period.
As the price movement of an asset moves up or down, the ATR indicator also moves simultaneously.
A new ATR reading is then taken as soon as a period passes. The traders can then have an idea about the volatility of assets during that period by calculating the ATR. The Average True Range is then displayed as a line on the charts that can be seen by the traders.
Working of Average True Range (ATR)
It helps traders to predict the trend and reveal the volatility in the market by calculating the averages of the true ranges. The higher value of ATR refers to higher price volatility and vice versa. Therefore, it is also used to calculate the signals of the Market sideways in addition to the trend changes.
Average True Range (ATR) is considered a non-directional indicator. More than predicting the correct direction of the change in trend, it predicts the occurrence of a change in trend more accurately.
It never tells the traders whether a bear market or bull market will happen. However, it helps the traders in finding out the volatility stop, deciding the target profits, detecting the entry signals and stop-loss placements, and finding the breakout points.
As the price changes and fluctuations for different markets and assets could be predicted by using the Average True Range (ATR), it is considered a universal indicator.
The volatility of any time period can be calculated and could range between the intraday frame of times to larger ones. It also helps in predicting the time when the market will accelerate in order to help active traders.
Analysis of Average True Range (ATR)
The fluctuation in the prices becomes larger and smaller as the ATR indicator shows movement on the graph. Similarly, ATR reading is calculated every day on the daily chart.
The graph is then plotted from all the readings being taken, and it gives a rough approximate idea to the traders about the fluctuations in the volatility over time.
Example of Average True Range (ATR)
To understand the example of Average True Range (ATR), let us assume that in a five-day ATR, the first value that is calculated is 1.41, and a true range of 1.09 is calculated over the sixth day.
By multiplying the last value of ATR by the number of days lessened by one and then adding to it the true range of the current period to the product, the sequential value of ATR could be estimated.
After this process, the sum is to be divided by the time frame that was chosen initially. One can also repeat the formula for the complete time period.
Though the direction in which the breakout will occur is not predicted by the Average True Range (ATR), still the trader can add it to the closing price. When the price on the next day increases above that value, the trader can then buy the assets.
Though the trading signals are quite infrequent, it still helps in spotting the important breakout points. A long-term position is considered a better way of taking an upward turn in the stock.
What Does Average True Range (ATR) Tell?
In reality, the concept of Average True Range (ATR) was produced for commodities, but now it is frequently being used for indices and stocks. A highly volatile stock will have a higher value of ATR, and in the same way, a stock with lower volatility will have a lesser ATR.
It is used to enter or exit any trade by market experts and as a tool that adds to their trading strategies. By using simple calculations, traders can measure the volatility in the market more accurately. Average True Range (ATR) is used to limit the upward and downward movements of the graphs and to find out the market volatility.
However, it does not talk about the direction of the market conditions. The only requirement to calculate the Average True Range (ATR) is the historical price value data, and it is so simple to be calculated. The method of entry into the market has nothing to do with it as ATR is normally considered as an exit method.
It also helps the traders in the derivatives market in order to determine the size of trade they need to put on. In addition to finding the measure of the market volatility, the approach of calculating the Average True Range (ATR) is helpful in determining the correct size of the accounts according to the willingness of the trader to accept the risks in the market.
Why Traders Use Average True Range (ATR)
The traders who deal with crypto trading are familiar with the volatility and fluctuation of the crypto market. They usually use different indicators in order to calculate price fluctuations. Therefore, the Average True Range (ATR) is considered a highly beneficial tool in the crypto market.
Day traders can plot the profit targets by using the information about the movement of the asset in the market. This then helps them to decide whether a trade should be carried out or not.
ATR is normally used by traders in order to set up stop-loss orders and take profit. The market noise can be avoided by using the ATR in this way. In case if one is observing a trend in the longer term, he would not require the volatility fluctuation values on an everyday basis.
In order to set the stop-loss beneath the price of entry, the most common method that is used is multiplying the value of ATR obtained by 1.5 or 2.
The value of the daily volatility lies above the stop-loss value calculated. If it touches the stop-loss trigger price, this provides an indicator to the traders that the market is moving in a downward direction.
Applications of Average True Range (ATR) in Risk Management
The Average True Range (ATR) based risk management will follow the following steps in order to find out the correct position in the market.
A Longer Position (Buy)
After the generation of the signal, a buy order is initiated by the algorithm. Then the ticks are monitored by the algorithm, and then a certain constant is multiplied by the Average True Range.
When the high value equalizes this value, a profit order or an exit order is initiated at the time of the trade. In the same way, if a low equals this value, a loss order is generated as a result.
A Shorter Position (Sell)
After the generation of the signal, a sell order is initiated by the algorithm. Then the ticks are monitored by the algorithm, and then a certain constant is multiplied by the Average True Range.
When the low value equalizes this value, a profit order or an exit order is initiated at the time of the trade. Similarly, if a high equals this value, a loss order is generated.
What is the Best Considered Setting for Average True Range (ATR)?
Average True Range (ATR) is always calculated for a certain period of time that is defined initially. ATR is then calculated by using a formula given. The defined period can be about 14 days or 14 hours, depending on the requirement of the trader.
The period for calculating the Average True Range (ATR) may keep on changing; that could be a month, a week, or some days. The experts can find out the volatility for a short term, such as some hours, or for a longer term that could range from days to weeks.
What is a Good Average True Range (ATR) Level?
The number used by most of the trading platforms is 14 periods by default; therefore, it is considered as a good period for Average True Range (ATR) calculation. It is taken as a reference by a number of good and reliable institutions.
Moreover, it is important for the traders to keep in mind the time frames of daily, weekly, or monthly tenures as many of the participants in the market have their eyes on the ones working for these values.
Limitations of Using Average True Range (ATR)
Predicting the change in price and the adaptability of the market, the Average True Range (ATR) helps traders in multiple ways. However, there are certain limitations attached to it too. The two major disadvantages of Average True Range (ATR) are given below.
Open to Interpretation
Average True Range (ATR) is totally a subjective indicator and open to interpretation. It means there is no value of ATR that would help the traders to know exactly if any existing trend will be reversed or not. The value that is predicted for the time being is then compared with the values in the past to understand the exact situation in the market.
Inability to Predict the Price of Assets
Another disadvantage of Average True Range (ATR) is that it does not predict the direction of the price of the assets; it only talks about the volatility of the market. This can also create a confusing situation sometimes especially when the market situations are being reversed or at pivot points.
In case the value of ATR increases suddenly, the traders may think that the trend is similar to some experience in the past, but this may not be the case sometimes.
Average True Range (ATR) is the key indicator when it comes to predicting the volatility of the market. It helps the traders in many ways, thus making the trade procedure easier for them.
It is considered one of the most commonly known technical tools that facilitate risk management or setting up targets for traders. The traders who become experts in calculating the Average True Range then can easily deal with volatile markets and fluctuating market conditions.
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