How to Use the ATR on Forex

The foreign exchange market moves quickly, and currency pairs constantly change their quoted exchange rate. In particularly busy trading sessions, for example, the euro/U.S. dollar quote can change several times a second. If the price quoted on a particular pair moves through a wider range of prices, the pair is relatively volatile. High volatility in currencies, as in other trading vehicles, means higher risk and a better chance that your position will either win or lose big.

Market statistician J. Welles Wilder developed the average true range indicator to show the relative volatility of currency pairs. Most currency-trading platforms will offer the ATR as an optional indicator that appears below the main screen. The indicator is actually a single number that is calculated by taking the average price range -- high to low -- over a selected period; a common setting is 14 periods. On a daily chart, for example, the ATR reading set at 14 will show the average price range over the past 14 trading days.

The higher the indicator moves, the greater the price range and the more volatile the currency pair. Traders use this number to adjust their "entry points" and set their stops, which close out their position if the trade moves against them. If you're trading the euro/U.S. dollar, for example, and the charts indicate a good buy entry at 1.3500, you would check the ATR for recent volatility. If the ATR number is 35, you would wait until the pair reaches 1.3535 before actually executing the trade. The price would have to fall beyond the ATR range to assure that ordinary recent volatility does not close you out at a loss too soon.

To use the ATR for stops, you would decide on a multiple of the ATR number and then apply it to your entry point. With the above example of a 35 ATR, for example, you might set a stop at two times ATR, or 70. If you entered the buy trade at 1.3535, you would set the stop loss at 1.3465. With this setting, if the pair moves 70 points against you, the platform automatically closes out your trade and limits your loss. The ATR multiple you use depends on the historic volatility of the pair. The higher the volatility, the wider your stops should be. The average true range is a useful indicator when dealing in stocks, precious metals, futures contracts or any trading vehicle that constantly fluctuates in value.