Hello Steemians, welcome to the first week of season 5 in the Steemit Crypto Academy. In this lesson today, we have been introduced to the Average True Range (ATR) indicator as one of the technical analysis tools essentially needed in making good trading decisions. Professor @kouba01 has done great to explain trading with the ATR indicator in its simplest form and it is in my interest to participate in the homework task.
Indicators are essential technical analysis tools that help to make good trading decisions about the behavior of the market and also the direction of the market. Although the majority of the indicators available focus on given buy and sell signals, or identifying the direction of price (Trends), it is observed that there are more benefits of indicators to traders than just given buy and sell signals and also identifying trends.
The average try range indicator is a volatility-based indicator that measures the volatility of the price. Aside from measuring volatility in the price of an asset, the ATR indicators also serve as a risk management tool that helps traders to exit the market when the price is in their favor and also to enter the market at the right time. The ATR indicators are essential for traders who wish to increase their trading success by managing their risk and understanding the market volatility before making any trading decision.
Indicators are generated from the mathematical calculation of previous or current price data points. In the case of the ATR indicator, the previous and current daily close on an asset is utilized in its calculation.
Let's explain some parameters for the ATR.
Range: This is defined as the difference between the high and low of a price for a particular trading day. The range has a direct relationship with the volatility of an asset. The higher the range, the higher the volatility of price for that day. Also, the lower the range, the lower the volatility of price for that day.
Range = High of price - Low of price
True Range: The true range gives an accurate measure of volatility than using the range. This is done by utilizing 3 mathematical equations. The true range is gotten by selecting the highest value gotten from these 3 equations.
The equations are as follows :
1st TR = Current High - Current Low
2nd TR = Current High - Previous Close
3rd TR = Current low- Previous close
The explanation for these 3 equations are as follows,
The 1st equation is utilized when the current candlestick bar is wider than the previous day’s price.
The 2nd equation is utilized when the current candlestick closes higher than the previous candle day candlestick.
The 3rd equation is utilized when the current candlestick body closes lower than the previous closing price.
From the above explanation, it can be assumed that the larger the candlestick range, the higher the ATR value.
The ATR is calculated by taking the simple moving average of the True range using 14 periods as default. For 14 days, the ATR is calculated by taking the True range in the last 14 days and dividing it by 14. This can be represented mathematically using the equation below.
ATR = max [(current high - current low), abs(current high - previous close), abs(Current low - Previous close)] / 14
After calculating the value of the first ATR using a defined period, the subsequent value of ATR can be calculated using the formula below,
Current ATR = [(Previous ATR × (n-1) + Current TR] / n, where n is the number of periods.
For example, the previous ATR for the 14 periods is calculated to be 4.5 and the maximum true range for the next day is 3.5. The current ATR will be equal to,
Current ATR = [(4.5 × (14-1) + (3.5)] / 14
Current ATR = (58.5 + 3.5) / 14
Current ATR = 62/14 = 4.42
From the calculation, we have a decreased ATR which shows a decreased volatility in the asset.
Best Setting of the ATR indicator period
Welles Wilder who is the founder of the ATR indicator chose 14 periods as the default period setting for the ATR indicator. 14 day period was assumed to give a clear trading signal from the indicator. Understand that the period is a very sensitive parameter of the indicator which determines how smooth a d accurate the ATR signal is.
While 14 period is chosen as the default setting, traders can select a period that best suits their trading style.
For example, a short-term trader (Scalper or day trader) will select a short period like 5 days to get recent price data. This means that the ATR will react to the recent price data points and smoothen the signal to the recent trading days.
Furthermore, a long-term trader (Swing / Position trader) will choose a longer period to get an accurate signal that best suits his trading timeframe. Let's look at the ATR chart in a different period.
From the chart we have above, we can see how the period affects the smoothness of the ATR indicator. The higher the period, the smoother the ATR signal, and the lower the period, the more sensitive the ATR reacts to the recent trading day and also the noisier the signal of the ATR indicator.
How to read the ATR Indicator, Reading the ATR indicator with other Tools
The ATR is very simple to read on the chart. The indicator measures the volatility of the market. This means that high volatility of price which is accompanied by larger candlestick bodies leads to corresponding larger values of the ATR. Similarly, the volatility is low in the market with smaller candlestick bodies, we tend to see a decreasing value of the ATR indicator. This can be seen in the chart below.
From the chart above, during a bearish high volatility market, we tend to see larger body candlesticks on the chart. This high volatility can be signaled by the ATR indicator increasing in value. The increasing value of the ATR shows that volatility is high in the market.
Similarly, we have a scenario of low volatility as seen in the chart below, after the high volatility we discussed earlier, we tend to see a decreasing value of the ATR indicator as volatility reduced in the market. From the chart, we can see small body candlesticks formed as price ranges within boundaries. Traders can capitalize on this information to make good trading decisions and also when to enter and exit the market.
Reading ATR indicator with other Tools
Indicators are prone to false signals due to sudden changes in the market. It is best advised to combine indicators with other technical analysis tools for proper confirmation of the signals from the indicator. From the lesson, it is observed that the ATR works best when combined with other tools like Parabolic Sar. In this section, I will be combining the ATR indicator with Bollinger band which is also a volatility-based indicator.
The Bollinger band is a volatility-based indicator that has an upper and lower band which are two standard deviations plotted above and below a 14 period moving average. I selected 14periodsd to have the same price data points in the last 14 days with the ATR indicator. The expansion of the Bollinger band signals indicates high volatility in the market as we see price breaking out of the upper and lower bands. Similarly, the contraction of the Bollinger band signals low volatility in the market.
From the chart above, we can see an expansion of the Bollinger band as we see larger candlesticks breaking below the lower band. This shows high volatility in the market which is also accompanied by an increasing value of the ATR indicator.
Similarly, from the chart below, we can see a decreasing value of the ATR indicator which shows decreasing volatility in the market. This signal can be confirmed using the Bollinger band as we see a contraction of the upper and lower band of the Bollinger band indicator.
Here, we have combined the Bollinger band indicator and the ATR indicator to confirm the signal from the ATR indicator. This can help increase the efficiency of the ATR indicator and also filter out the noise and filter out false signals.
Determining Price Volatility and Price Dominance Using the ATR indicator
Determining Price Volatility
Just like we have established in the previous section, there is a direct reflection of the price volatility on the ATR indicator. An increase in price volatility which leads to larger body candlesticks formation can be seen on the ATR indicator as value spikes up.
Looking at the chart of BTC/USD above, from box  we can see an increased in volatility as price spikes down from $52.6k to $43k>. This was accompanied by larger candlestick bodies as the ATR indicator also spikes up to a higher value.
Similarly, after the spike in the box (1), from the box (2) we tend to see reduced volatility in the price as price ranges with the formation of smaller candlestick bodies. This reduced price volatility can be signaled by the ATR indicator as to the value decreases. The same situations can also be spotted in boxes (3) and (4).
From what we have discussed, we can see how a change in the ATR indicator is accompanied by an impulse price reversal as seen in the box (1) and box (3).
Determining Dominant Force on the Price
The volatility of price on the chart should correspond with the ATR indicator in other to determine the dominant force. This can be bullish or bearish as seen during strong trends. Using this information, we can determine the trend that corresponds with the ATR indicator.
Looking at the chart above, the price was increasing and going up but the ATR indicator is signaling reduced volatility with a decreasing value. This depicts that the up movement does not correspond to the dominant force on the price.
This means that there is not enough bullish momentum responsible for this up movement. A trader can use this information to avoid faking out and falling for traps in the market. We can see how the ATR indicator reversed with an increased spike which triggered the drop in the price of BTC/USDT.
Looking at the chart above, we can see a reversal of the ATR indicator with a sharp spike upward. This is in correspondence with the price as we see price fall. This means that the dominant force of the sellers pushing price down corresponds with the ATR indicator.
In conclusion, looking at the overall information on the chart, boxes (1 and 3) do not correspond with the dominant force of the buyers pushing the price up as we see the decreasing value of the ATR indicator. After that, we can see a price reversal inbox (2 and 4) which corresponds with the ATR indicator showing that the sellers are dominating the market.
Using the ATR indicator to Manage Trading Risk
As a cryptocurrency trader, I believe that risk management covers 70% of the outcome of a trade. Even if you have a good background in technical analysis to predict future prices, not being able to manage risk in the market will still ruin your trading journey.
The crypto market is highly volatile and this makes the market a risky one. Good risk management is required to exit the market when in loss (Stoploss) and also when the market goes in your favor (Take profit).
The benefit of ATR is also extended towards finding better risk management for your trade. This feature is rare for most indicators.
Stoploss: Closing your Trade when in loss
The market won’t always go according to our prediction. An exit strategy is required to close your position when the market is against your prediction to avoid blowing your account. Stoploss is a pending order placed to automatically exit your position when the market is against your prediction.
A stop-loss cannot be too tight as not to get triggered too quickly. Similarly, a stop-loss won't be too wide to minimize losses when things go wrong. The ATR indicator helps to spot a strategic position for your stop-loss. The formula used will be:
Stoploss: Entry price +/- 3x ATR value.
For example, assuming I have a sell entry price for BTC/USD at $63.97k and the current ATR value is 1015. Now calculating the stop loss point using the formula above gives:
Stoploss = $63973 + (3 × 1015)
Stoploss = $67055.
This means that I will set my stop loss at $67055. This can be seen in the chart below ad the position is found above the recent high. The chances of price reversing back to this point are low and if the price should eventually get to the stop loss leave, it means that the setup is invalidated. Here ATR indicator has helped to place a Stoploss at a strategic position.
Take Profit: Closing a position when in Profit
Taking profit is essential in trading as the goal of trading is to make a profit. When you don't have a good exit strategy when in profit, you can either leave money on the table by having a closer take profit, or your price can reverse on you without reaching your take profit when you set a high take profit.
We understand that the ATR indicator measures the volatility of price over the last 14 periods. This means that the current ATR value is seen to be the likely point price will get for the day. Traders can use this information to set take profit targets.
Let's assume that the current ATR is 1000pips. This means that the average range price will get to is 1000pips. This makes setting a take profit position below 1000pips as this is a viable range price will cover.
From the chart above, I have used **Entry price +/- 3ATR value to determine the take profit. I chose this strategy to maintain a 1:1 risk management on my trades.
For example, in the example I gave earlier, take profit position will be calculated as :
Take profit: 63973 - (3 ×1015)
Take profit = $60965
Using the ATR to get this point, there's a likelihood that the price will drop to this value.
From the chart above, I have provided a stop-loss target which will give my trade more room to get to the take profit. This is one of the amazing features of the ATR indicator in maintaining risk in the market.
From the chart above, we can see that take profit is already triggered in a few hours. We can see the importance of using the ATR indicator to have a good take profit position.
Highlighting Strength of Trends and Trend Reversal Signs
A trend is identified by an impulsive or gradual move of price in a particular direction. Though the ATR indicator can't identify the direction of a trend, the indicator can be used to determine the strength of a trend. This means that the ATR indicator will be used in conjunction with price action to identify the strength of a trend.
During ranging markets, price bounces off support and resistance levels to gather momentum for the beginning of a new trend. Price can break out either upward or downward depending on the forcing force between the buyers and the sellers.
The reflection of price movement on the ATR indicator can be used to determine the strength of a trend. From the chart below, we can see how broke a major resistance after a reversal. Initially, the strength of this trend reversal wasn't seen on the ATR indicator as there was no increased value to confirm the strength of the new trend.
Looking at the chart, we can see that price broke the major resistance level which is a strong indication that the uptrend is valid. We can see the strength of this new trend from the increasing value of the ATR indicator. This shows that buyers have a dominant force in the market to push price upper as the strength of the uptrend was able to break the resistance level.
Trend Reversal signs
During a trending market, the ATR indicator is used to determine the dominant force in the market. This is seen by an increasing value of the ATR indicator accompanied by price action. After price has recorded a high peak or when there's trend exhaustion, we tend to see the ATR decreasing in value. This means that there's no volatility or dominant force to continue pushing price in the direction of the trend. After this, we expect a reversal in the opposite direction.
From the chart below, after a bearish trend that recorded a high value of ATR, we tend to see weakness in the trend as price was ranging. Similarly, this trend weakness can be seen as the ATR indicator was decreasing in value. This signal tells that there's no volatility or strength to keep pushing price down. After some time, there was a reversal from bearish to bullish as price broke above the resistance. This trend reversal was further confirmed using the ATR indicator as the value was increasing.
Advantages and Disadvantages of the ATR indicator
The ATR indicator is simple to read on the chart. Unlike other technical indicators that are complicated to understand the trading signal.
Unlike other volatility-based indicators like the Bollinger band, the ATR indicator gives a clear picture and reflection of the evolution of prices and volatility. This can help traders understand the current market condition before making any trading decision.
The ATR also serves as a good risk management tool that helps to identify strategic stop loss and take profit positions. This can help to minimize losses as these targets are placed within the average daily price movement of the market.
The ATR indicator is compatible with any trading strategy and any timeframe. All you need to do is to set the brand that best suits your trading style.
Though the ATR indicator can be integrated into a trading style, the indicator does not give a direct buy and sell signal to traders. Traders cannot make entry positions using the volatility signal given by the indicator.
The efficiency of the ATR indicator can only be maximized when it is used in conjunction with other technical analysis tools. Using the indicator as a standalone tool makes it prone to false signals which can lead to poor trading performance.
The ATR value does not tell about trend reversal or continuation. The indicator is focused on measuring volatility in the market and not the market direction. This makes it difficult to identify the strength or weakness of a trend using the indicator.
Indicators are important technical analysis tools that produce good trading signals when properly used. The ATR indicator plays a vital role in identifying market volatility. Similarly, the indicator has a unique feature of determining stop loss and take profit positions which makes it a good risk management tool.
The ATR indicator is best used with other technical analysis tools like the Parabolic Sar and Bollinger bands to increase its efficiency and also filter out false signals. Traders are advised to understand their trading strategy and then use ATR settings that best suit their trading style for a successful trading journey.
Thank you professor @kouba01 for this amazing lesson.