The ATR indicator measures the volatility of an asset’s price over a given time duration. Most experts advise traders not to use the ATR indicator as a standalone indicator. Instead, they recommend using it to confirm trade signals generated using other methods.
The logic behind this advice is that there are several factors that contribute to an instrument’s price action, including volatility. However, there are many ways in which you can use the ATR indicator as a crucial component of your trading strategy.
Using the ATR to find explosive breakout trades
As a volatility indicator, the ATR can be used to identify potential breakout trades that could lead to massive bullish and bearish trends if identified early. A key principle behind volatility is that periods of low volatility are usually followed by periods of high volatility and vice versa, as demonstrated in the chart below.
Chart 1: ATR breakout trades on the USOIL daily chart
The above chart shows a bearish trade setup that occurred at a crucial point where the ATR indicator was shifting from extremely low values and embarking on an uptrend, indicating that a period of high volatility was about to begin.
The chart also shows a breakout trade that occurred at the highest point reached by the ATR indicator before the volatility levels started dropping and a strong bullish trend ensued, validating the core principle that periods of high volatility are usually followed by periods of low volatility.
You could have identified the above trade setups from the EMA crossover, but the ATR values would have provided a strong confirmation that the trade setups had a high probability of playing out as expected.
Using the ATR indicator as a trailing stop loss
Another effective way to use the ATR indicator is as a stop-loss order whereby you can use a multiple of the ATR value as your stop-loss order. For example, in the USOIL chart below, the ATR value at the entry point to the bullish trade was 2.62; you could have multiplied this value by 2 to get 5.24 and then use this as your stop loss distance.
Chart 2: The ATR indicator as a trailing stop-loss order
The two lines on the above chart represent ATR values that could be used as stop-loss orders. The upper line represents 1 ATR value, while the second line represents 2 ATRs. Aggressive traders may choose to place their stop-loss orders at the first line in order to increase their risk-to-reward ratio, but they are in great danger of being stopped by sudden price swings.
On the other hand, conservative traders may prefer to place their stop-loss orders at the second line to stay in the trade for much longer, but this will definitely lower their risk-to-reward ratio.
Tips for trading based on the ATR
As you can see in the above example, the ATR-based strategy worked extremely well on the USOIL chart because the price was trending. The chart shows that the price was in a strong downtrend before bottoming and entering into a solid uptrend. The same cannot be said of sideways trending markets or choppy markets where price whipsaws in both directions.
Chart 3: The ATR indicator on the EUR/USD 1-hour chart
As you can see, the ATR indicator is not trending in the above chart despite the presence of a sustained downtrend and uptrend, which makes it impossible to use the indicator to identify high-probability trade setups.
Using the ATR to set profit targets
You can also use the ATR to set your profit targets by determining the average ATR value for a specific period and setting your profit target based on this value.
For example, if a currency pair moves an average of 70 pips each day and you have a trade with a potential profit target of 200 pips, you should plan on holding the currency pair for at least three days or longer to hit your profit target.
The bottom line
The ATR indicator is a powerful volatility indicator that can be used to find high-probability trade setups in trending markets. You can also use the ATR indicator to set your profit targets as well as stop-loss orders. However, it is not advisable to use the ATR indicator as a standalone indicator.