The Average True Range (ATR) indicator is a very helpful instrument to judge the volatility of an asset. If you are trading option types requiring high volatility, for example Boundary or Touch / No Touch options, the average true range can help you take your trading to the next level.
What is the average true range?
The average true ranges calculates the average volatility of an asset over the last periods by subtracting the high of each period from the low and creating a smoothed moving average of the results. J. Welles Wilder, the inventor of the average true range, recommended using it over the last 14 periods, which still is the most common setting. Some traders also use the average true range with 30 periods.
As you can see in the picture above, the average true range uses a separate window below your price chart. The average volatility is symbolized by the blue line. By using the average true range indicator, you can quickly asses a stock’s average daily movement. Usually, the value is displayed to the right side of the indicator line.
How to trade the average true range
Most commonly, the average true range is used to find a reversal entry point. By comparing the average daily movement calculated by the ATR and today’s movement, you can predict how far today’s movement is likely to continue.
Let’s imagine a stock with a price of $100 and average daily movement of $2 over the last 30 days. If the stock has only moved $0.25 in one direction today, you know that there is still a lot of room left for prices to continue in this direction. Once stock has moved $1.50, though, you know you have to be careful, and should start looking for any indication of a turnaround.
If the stock hits $2.50 for the day, you know that this is a huge profit for most traders, and that some of them will likely start taking their profits. Therefore, this is the perfect time to invest in a turnaround. You can invest in a No Touch option in the direction of the current price movement. If your prediction is right, prices will either remain at their current level or turn around, and you will win your no touch option.
By the same logic, you can invest in a High / Low. A High / Low option involves more risk, but can generate a higher payout. Of course, you can keep your trading strategy as simple as in this example, or you can try to enhance it. For example, you could use candlestick formations indicating a turnaround in price direction to find especially good entry points.
You could also use another indicator to judge the momentum of the daily movement, and invest once it starts to weaken, after the price has crossed your predetermined range.
Thirdly, trend analysis could help you find the turnaround point. On smaller timescales, the simple up and down movement of the current period will translate into a number of bullish and bearish trends. Once the price has crossed your average true range, you can start to look for an expiring trend on a smaller timescale. Once you find it, you have a good chance of finding the exact turnaround point.
Again, your strategy should depend on your personality.
Keep in mind: Don’t make your strategy too complicated. If you add one or two methods to the average true range you might be able to reduce risk, if you do it right. Still, the more methods you combine, the fewer signals you will get, and the lower your winning potential will be.