Measuring Volatility with Average True Range

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By Jeremy Wagner, Lead Trading Instructor, 11 August 2011 13:37 GMT By : Jeremy Wagner, Lead Trading Instructor, DailyFX Education

Average True Range (ATR) is a tool used in technical analysis to measure volatility. This indicator does not provide an implication for the direction of price trend. It simply measures the degree of price volatility from high to low for the day.

A simplified explanation of the ATR is that it measures the range of a session in pips and then determines the average of that range over a certain number of sessions. For instance, if using a daily chart with a default setting of 14, the ATR will measure the average daily range, from high to low of the previous 14 days. This way you are getting a current reading on the volatility of a specific currency pair. The idea is that large and increasing values shows ranges that are expanding. As the market normally breathes in and out, this expansion of volatility indicates to us how far prices may reach.

As a result, many traders us ATR as a method to identify and limit risk on trades. For example, if you typically hold trades open for at least a day, you will want to use a stop loss level that is at least 1 Daily ATR value away. That way, as the market goes through its normal breathing, the majority of the movement is likely to be contained within 1 ATR value.

Let’s compare 2 different markets with different ATR values.

(Created using FXCM’s Marketscope 2.0 charts)

The current 14 day ATR for the EUR/GBP is about 82 pips while the same 14 day ATR for the GBP/AUD is more than three times that amount at about 256 pips. So we can see why a standard 100 pip stop is not the best way to determine your risk on every trade. Many traders will simply use the ATR for their risk. They would place their stop 82 pips from their entry in a EUR/GBP trade or 256 pips from their entry in a GBP/AUD trade. This is one way to base your risk on the reality of the current market you are trading.

Another interesting point on the charts above is where values have generally stood over the recent past. As you can see in the EUR/GBP, it has produced ATR values less than 100 pips for the majority of the previous 12 months.

On the GBP/AUD, at its lowest zone of volatility (red boxed area), it averaged around 140 pips. It is apparent the volatility on the GBP/AUD reaches beyond the current market conditions. It has historically had 2-3 times the size of volatility as the EUR/GBP.

Additional educational resources

How Do I Know If a Stop is Too Big

Money Management Lesson 1 Video

Jeremy Wagner contributes to the Instructor Trading Tips articles.

http://www.dailyfx.com/how_to_trade_forex/course_trading_tips

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11 August 2011 13:37 GMT

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Detection and markets related to the range trade

We will go over various methods of detection and trade in the range-bound markets.
Participate in the discovery of new ideas, indicators and tools to take additional control bound to the trading range.
The fact is that for the majority of markets well oriented trade of traders Forex profitably and comfortably, but once a trend in all sorts of problems arise: trend-following systems no longer work, frequency of entry of false signals increases bringing additional losses that eat earlier accumulated profits.
Given that the Forex market is spending up to 50% of time State trending, sideways, the knowledge of how to deal with the range bound markets becomes vital.
...Its beginning is difficult to detect. Very often at the time that we realize that the market is going we already made a few errors and paid for it.
There are various strategies that tell how to trade in the range-bound markets, but there are few who teach the How to spot range-bound markets on their early stages, so that we can in fact a choice: to trade or to avoid it.
# 1: We will discuss ideas for detecting and trade in the range-bound markets and methods. These methods do not completely protect you never modify weather market, but you will anticipate and take "weather forecast" with extra precision.
# 2: We will use the primary rule: If the market is not a trend, still treat it as a range market.
When you use the indicator signals, if a flag no longer displays the signs of a trend in good health, immediately treat it as a start of a range market linked to further improvements.
# 3: There are few systems that can exchange really well during the two: ranging and trends in the markets, more often it is one or the other. If your trading system keeps losing during ranging from markets, you have two options: a. stop trade in range-bound markets. b. do an additional system to use during this period.
Truly yours,
Edward Revy
and my best strategies Forex team