Quantifying Volatility: How to Match Your Trading to the Market with the Average True Range Indicator in MT4

Many technical analysts are adept at judging a market by simply eyeballing a chart, though there is always a drawback in this method of maintaining consistency. It isn't that difficult to look at a chart and spot periods that are more volatile than others — that is, stretches where the market is more active and price movements occur more quickly. But what do we do when we want a more qualitative approach to gauging market volatility?

When trying to assign a numerical measure to volatility, the most direct value to look at is the range of the market — how much the market moves in a given time.

The most obvious way to measure range is to look at the difference between the highest price and the lowest price in one time frame and call that the trading range. Simple, right?

Well, not always. One of the best-known technical analysts to first write at length about using volatility as an indicator was J. Welles Wilder. In his 1978 book New Concepts in Technical Trading, he introduced many cornerstones of modern technical analysis, including the Relative Strength Index (RSI), the Average Directional Index (ADX) and Parabolic SAR Indicator (PSAR).

Among this deluge of influential indicators was one designed expressly for the purposes of measuring volatility — the Average True Range indicator (or ATR indicator).

This article is going to discuss what exactly the indicator measures and how to use it with MetaTrader 4. We'll also look at how it can be used as part of a trading system.

What is the ATR indicator?

J. Welles Wilder developed his indicators while looking at the commodity markets. He realised that solely looking at the day's range was too simplistic a measure of volatility. This is because of the way in which commodities frequently go limit up or limit down — or gap in price from the previous day's close to the new opening.

This meant to adequately reflect the true volatility of the market, he needed to consider also the previous day's close as well as the current high and low. Proceeding from this realisation, he defined the true range as being the greatest out of the three following values:

the distance between the current high and the current low the distance between the previous close and the current high the distance between the previous close and the current low.

Wilder then proposed taking an average of this value over several days in order to provide a meaningful representation of volatility. Logically enough, he called this the Average True Range.

The ATR equation

The ATR for the current period is calculated as follows over n periods:

ATR = Previous ATR (n-1) + True Range of current periodn

As the equation requires a previous value of ATR, we need to do a different calculation to obtain an initial value of ATR. This is because for the initial ATR we will, by definition, have no previous value to use. For the initial ATR, we simply take the arithmetic mean of the true range over the prior n periods.

So what value should you use for n?

If you average over a greater number of days, you obtain a slower volatility indicator. If you use a fewer number of days, you will have a fast volatility measure. Wilder recommended using 7 or 14 days for optimal performance, depending on which trading system he was using. As we shall see, 14 is the default value used in MetaTrader 4.

We don't really have to worry too much about the calculation method, of course, as MetaTrader 4 will do all the calculations for you. If you want to read more about volatility in general, you might enjoy our article on using a Forex volatility indicator.

Let's now look at using the ATR indicator in MT4.

ATR Indicator MT4

ATR comes as one of the standard package of indicators when you install MT4. There is, therefore, no need to make a separate ATR indicator MT4 download, which is handy. I prefer to have as wide a selection of tools available in one go without having to separately download indicators in a piecemeal fashion.

If you're like me, and want to add a wide selection of tools and indicators in one simple download, you should consider installing MetaTrader 4 Supreme Edition. It's a plugin that's been specifically developed by professionals — and offers a useful bag of tools above and beyond the default indicators you get with the vanilla version of MT4.

You will find ATR listed in the Indicators section of MT4's Navigator. When you launch the indicator, the only variable you really need to think about is the ATR Period. This is the number of periods over which MT4 calculates the average. As shown below, the default value is 14, which is an excellent choice to begin with.

Once you click OK, a graph showing the value of ATR appears beneath your main chart. Shown below is an hourly USD/JPY chart with a 14-hour ATR applied:

The peaks on the ATR chart show more volatile trading times; the troughs indicate less volatile periods. Hovering your cursor on the line chart will give you the exact value of the ATR at that point in time.

How to use the ATR indicator in trading

Wilder originally proposed an ATR trading strategy that was a core part of his trend-following volatility system. The rules assume you have entered a trade following the trend — for example, buying into a market making new highs each day.

The rules of this ATR trading system are reasonably simple to follow and effectively dictate where to stop and reverse your position:

Multiply the ATR by a constant. Wilder recommended 3.0 as the constant and called the resulting value the ARC. Find the significant close (SIC). This is the extreme favourable close in the preceding n days. You square and reverse your position one ARC from the SIC.

This was designed to be used with daily values and for these rules, n was set at 7 to give a sufficiently fast reaction to volatility.

In a broad sense, you can use ATR as a guide to appetite in the market for pursuing price moves. For example, if a market moves higher, it is only if strong appetite remains for further buying that the range will continue to extend. Should ranges narrow, some may interpret that as suggestive of declining interest in pursuing the net directional movement.

Other ATR trading uses

Because it gauges market volatility, you can also use ATR as a tool for guiding stop and limit placement and also for position sizing. These uses are probably more prevalent these days than as a generator of trading signals.

The famous Turtles — a group of novices who achieved great trading success in the eighties after just a few weeks training — used ATR for position sizing. They did this to normalise the dollar volatility of their positions. Their trading rules called for them to trade on any one of more than twenty different contracts, based on price movement.

As they did not know which positions would win or lose, they needed to adjust for the volatility of the different markets. This prevented, for example, taking a large loss just because that contract happened to move more than others. They specifically used the 20-day ATR. The higher the value, the smaller the position they took and vice versa.

ATR indicator in summary

The ATR indicator was originally designed with commodities in mind, but today it is widely applied to stocks and Forex. The Turtles mentioned above, for example, traded a cross-section of bond, commodity and Forex futures and used ATR as their position-sizing tool for all. ATR Forex sizing works just as well as ATR commodity sizing, because volatility is a universal market concept.

Because ATR does not measure direction and simply considers the magnitude of range, it has limited utility as a means for generating trading signals. But it is a useful tool for giving an idea about how much a market may move. This, in turn, informs key trading decisions such as position size and stop placement.

To find out how it can aid you in these areas, why not experiment using ATR in our risk-free demo trading account and see what works best for you? We hope this article has helped you discover a useful tool to aid your trading.