Enhancing risk management using the Average True Range (ATR) indicator

As a trader, managing risk is one of the most critical aspects of your success. Utilising effective tools and indicators can help you navigate market volatility and protect your trades

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What is the Average True Range (ATR)?

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The ATR (Average True Range), created by J. Welles Wilder Jr., measures an asset's volatility, like stocks, currencies, commodities, or even Derived Indices. Unlike indicators that track price direction, ATR focuses solely on the range of price movement. It adapts to various market conditions and timeframes, making it valuable for traders managing risk.

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Why do traders use Average True Range (ATR)?

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Traders use the ATR for two main reasons:

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1. Position sizing: The ATR helps traders adjust the size of their trades based on current market volatility. This allows them to align their risk with their individual risk tolerance.
2. Stop-loss and take-profit placement: The ATR can aid traders in determining effective levels for their stop-loss and take-profit orders. This helps to accommodate market fluctuations and manage risk.

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How to use the ATR indicator on Deriv's trading platforms

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All of Deriv’s CFD platforms allow you to add the ATR indicator to your trading charts, with no need for any manual calculations, the platform automatically handles the math for you.

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However, if you are curious about how to calculate ATR, you have to find the largest value among: 

• The current high minus the current low
• The absolute value of the current high minus the previous close
• The absolute value of the current low minus the previous close

The ATR is then determined by averaging these true ranges over a set number of periods.

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To set it up on an MT5 chart, you simply have to choose a period length. Many traders use a 14-day period as it’s a common standard. Keep in mind, though, that a longer period makes the ATR line smoother by averaging more data points. However, it also slows the indicator’s response to recent market changes, meaning it may not pick up on sudden shifts in volatility as quickly.

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Interpreting the Average True Range (ATR) value

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This indicator gives a single number showing the average price movement over a chosen period, providing valuable information about market volatility:

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• Higher ATR values: Indicate increased volatility, suggesting larger price swings.
• Lower ATR values: Suggest lower volatility, indicating smaller price movements.

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More volatile assets naturally have higher ATR values, while less volatile ones have lower values. 

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Changes in volatility often come before big price movements, a sudden jumps in ATR may hint at a possible imminent breakout or trend reversal, making these shifts useful for timing entries and exits. By understanding these readings, traders can make informed decisions about their trading positions and overall risk management. 

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How to use the Average True Range (ATR) indicator for risk management

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Take-profit and stop-loss orders using ATR

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• Since ATR reflects an asset's average volatility, it can guide traders in placing limit orders at a reasonable distance from the entry price.
• For example, if the ATR for the Volatility 25 Index is $8.5 and you buy at $100, you might set your SL at two times the ATR $83 and your TP at three times the ATR at $125.50.
• When the ATR is higher, you can position your TP and SL further from your entry price. This provides the price with more room to move without prematurely triggering your orders.

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Position sizing using ATR

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• ATR can also assist in determining your position size. A common strategy is to risk only 1 ATR unit per trade. In this case, with an ATR of $8.5, you would risk a maximum of $8.5 on the trade.
• This approach ensures that your position size is aligned with the asset's typical daily movement, helping you manage market fluctuations more effectively.

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ATR usage considerations

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While the ATR is a valuable tool, it's important to understand its limitations:

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• Lagging Indicator: The ATR reflects past price movements, so it may not always accurately predict future volatility.
• Complementary Use: The ATR should be used alongside other technical indicators and fundamental analysis to make well-informed trading decisions. Remember, no single indicator can provide a complete picture of the market. By combining the ATR with other analysis techniques, you can make more informed trading choices.

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The ATR indicator can help you make more informed and disciplined trading decisions. It's important to practice using the ATR in a free demo trading account before applying it to your live trades. This will help you get comfortable with how the indicator works and how to integrate it into your overall trading strategy.