Developed by J. Welles Wilder, the Average True Range (ATR) measures volatility of the forex market. Originally Wilder derived the True Range index for commodities and daily prices. Later Wilder realized that a simple range calculation was not always efficient as applied to market volatility trends. Consequently, he smoothed the True Range using the moving average and obtained the Average True Range (ATR). In other words, ATR is the moving average of the TR for a prescribed time period (usually 2 weeks).
Recall that the TR is given by TR = H – L , for the “normal” days, TR = H – Cl, for days that open with an upward gap, TR = Cl – L, for days which opened with a downward gap, where H is the today's high, L the today's low and Cl the yesterday's close. The Figure below illustrates how the ATR works. During more volatile markets ATR moves up whereas for less volatile market ATR moves down. When the candlestick price bars are short the Forex traders see the ATR indicator moving lower. If price bars begin to grow the ATR indicator line will rise.
Let us show how to avoid the whipsaws. Recall that the whipsaw is a point in the market where the price moves sharply up or down. In the early stages the whipsaw looks similar to the start of a new trend. However, instead of continuing the trend or leveling off it will suddenly dive back down or up to a price close to where it started.
Suppose that the trader has a breakout system that tells where to enter. Consider a breakout system that triggers an entry buy order once market breaks above its previous day high. Let’s say this high was at 1.3000 for EURUSD. Without any filters we would buy at 1.3002, but are we risking to be whipsawed.
With ATR filter the forex trader measures the ATR first. Suppose that he has found that for EURUSD the 14 day ATR stands at 110 pips. He may choose to enter at breakout + 20% ATR (110 x 20% = 22 pips). Therefore, instead of rushing in on a breakout and risking to be whipsawed, he enters at 1.3000 + 22 pips = 1.3022. Finally, although the trader gave up some initial pips on a breakout, an additional measure has been taken to avoid being whipsawed.
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