Introduce
Trading is notorious for its high volatility, especially in the cryptocurrency space. Traders often try to capitalize on price movements and predict them.
One popular method is to use technical analysis and price volatility indicators, such as Average True Range (ATR).
For many traders, this is a useful tool to gain insight and add to their technical analysis toolkit.
What is Average True Range?
Average True Range (ATR) was developed by technical analyst J. Welles Wilder Jr. in 1978 to measure price volatility. Since then, ATR has become one of the most widely recognized price volatility indicators.
ATR is currently an important part of other indicators that help determine the direction of market movement, such as the Average Directional Movement Index (ADX) and the Average Directional Movement Index Rating (ADXR).
With ATR, traders attempt to determine the optimal time to trade during periods of high volatility.
This indicator calculates the average price of an asset over a 14-day period. ATR does not provide information about trends or price direction but merely shows the level of price volatility during that period.
A high ATR indicates significant price volatility, while a low ATR indicates minor fluctuations.
When deciding to buy or sell an asset during a period, traders often consider this high or low price volatility.
However, it is important to note that ATR is only a reference for price volatility and should be used as a supportive tool.
How to calculate Average True Range
To calculate the Average True Range, the largest True Range (TR) needs to be identified over a period. This includes calculating three ranges and selecting the largest value among them:
The highest price during the period minus the lowest price.
The absolute value (ignoring negative signs) of the highest price compared to the previous closing price.
The absolute value of the lowest price compared to the previous closing price.
The selected period may vary depending on the trader's focus. For example, for cryptocurrencies, the period might be 24 hours, while for stocks, the period is usually one trading day.
To calculate the average ATR over a period (usually 14 days), sum the TRs from each period, then take the simple average.
Determining the ATR allows traders to better understand the level of price volatility of the asset during that time.
ATR is often displayed as a line on the chart, and as volatility increases, the ATR line also rises.
Why do cryptocurrency traders use Average True Range?
Cryptocurrency traders often use the Average True Range to estimate price volatility over a certain period. ATR is particularly useful in the cryptocurrency market due to its high volatility.
A common strategy is to use ATR to set profit-taking and stop-loss levels.
When using ATR in this way, you can avoid minor fluctuations affecting your trading strategy. If you are trying to trade with a long-term trend, you don’t want daily volatility to close your position early.
A common method is to multiply ATR by 1.5 or 2 to set a stop-loss level below the entry price. Daily volatility should not reach this stop-loss level; if it does, it indicates that the market is declining sharply.
Disadvantages of Average True Range
Although Average True Range offers benefits due to its flexibility and ability to detect price volatility, it also has two main disadvantages:
ATR is subjective. There is no specific ATR value that can clearly indicate whether a trend will reverse.
ATR measures price volatility only and does not provide information about price direction. For example, when ATR suddenly increases, some traders may assume it confirms a previous upward or downward trend, but this may be incorrect.
Conclusion
ATR is an important tool in the toolkit of many traders to understand price volatility patterns.
With volatility being a key factor in cryptocurrency trading, ATR is particularly suitable for digital assets.
Its strength lies in its simplicity, but be aware of the limitations of this indicator if you decide to experiment with it in your trading activities.