By calculating the average true range, you can accurately measure the daily volatility of the currency pairs and identify gaps as well as limits in Forex trading.
The average true range is an essential component for the technical analysis of any market and it was initially developed for commodities. However, it has since been extended to be used in all kinds of markets including stocks, Forex, and more.
It provides vital information about the likelihood of a Forex market moving up and down with time and helps determine placements of the right stop-loss order level.
It is derived from the 14-day simple moving average of a complete series of the true range and is also known as a market volatility indicator because it allows traders to measure the daily volatility of the currency pairs by averaging their values.
The average true range in Forex trading shows how much a currency moves on an average during the entire day. It helps day traders decide when they want to initiate a trade or exit from it. The average true range is also used to determine where a trader should place a stop-loss order to minimize risks.
The average true range moves up and down and it is represented as a graph or chart, with the price moves becoming larger or smaller during the day. Since a new price chart is formed every day, the average true range can be calculated on a daily basis. These readings are plotted from an ongoing line, enabling traders to identify how volatility has been changing over time.
Let us understand how to use an average true range with an example.
Assuming we want to calculate the average true range for 5 trading days and beyond. Let us suppose that the first value that we calculated for the five-day average true range comes out to be 1.41. On the sixth day, the market has a true range of 1.09. A trader can calculate the sequential average true range value simply by multiplying the previous average true range value by the number of days considered minus one, and then the current true range should be added to this product.
As the next step, the trader should divide the sum by their selected time frame. Let us assume that the second average true range value comes to be 1.35 (1.41 * (5-1) + (1.09))/5), as per the values we have considered. The formula can be repeated over the entire time frame in which the trader wishes to examine the average true range value.
If the prices move against the average true range value that we calculate, the trader can put a stop loss to exit the trade at a feasible price and minimize risks and losses. However, if the prices move in favor with respect to the average true range, a trader can short the trade to make profits.
Trading signals can be generated either every 14 days or a lesser timeframe. For example, traders can assume a short-term period with the goal of only analyzing the volatility of a currency pair over 5 trading days time. The trader can then calculate its 5-day average true range.
Here are the steps to identify and calculate the average true range:
The trader needs to find the first absolute value by subtracting the current low price of the currency from the current high price.
They then need to find the second absolute value by subtracting the previous close price from the current highest price, assuming that the data is arranged in reverse chronological order.
The last calculation is to find the absolute value by subtracting the previous close price from the current lowest price of the currency, from the same historical data.
The last step is to consider the maximum value out of these 3 values. The value you get is your average true range for day 1.
Repeat these calculations for all 5 trading days.
Average these calculations by dividing the summation of all the average true range values by 5 (the time frame).
You get the averaged first value of the five-day average true range.
Through this process, a trader can determine the average true value for the 5 trading days and understand the entry and exit points of the trade that suits the trader the best.
As mentioned above, you need to find a series of true ranges for the currency pair you are trading in or wish to trade-in. The price range of these currencies on any given day is its highest value minus its lowest value. Below is the average true range formula for faster and easier calculations :
True range = Maximum [(Highest value – Current low price), Absolute (Highest value – previous close price), Absolute (Lowest value – Previous close price)
Average true range = (1/n) SIGMA n, i=1 True range (i)
Where n = the total time period
The average true range’s main objective is to determine market volatility and confirm a trader the right price level at which they can either initiate a trade or fix a stop-loss order to exit the trade when needed.
A trailing stop loss is a way a trader exits a trade if the currency price moves against the trader’s wish. It enables traders to see where to put their trailing stop losses to ensure minimized risk and maximized profits.
The rational stop-loss price point can be determined by looking at the current average true range reading and then multiplying it by 2.5 (the trader can take any value between 2.5-3.5). When there is an up-trend, subtract this value that you get from the closing price of the currency and plot it as the stop for the current day. Continue subtracting the average true range value multiplied by 2.5 from each day’s closing price until the price reverses below the average true range stop.
However, if the price closes below the average true range stop, you can add this value by multiplying the average true range by 2.5 to the closing price and track a short trade.
By doing the above, you can place your stop loss at a level that is two and a half times below the average true range value. However, in the case of shorting, the stop loss is placed at two and a half times above the entry price.
When prices are moving in a favorable direction, you should continue to push the stop loss to 2.5 times the average true range, which is also below the currency’s price. Once the stop loss moves up, it stays there until it again faces an up-trend or the trade is ended as a result of the price drop to hit the trailing stop loss level. The process works in the same way, even for short trades, only in the opposite direction.
The average true range has two main limitations:
The average true range is a subjective measure. It is open to interpretation and not factually accurate at all times. There is not a single average true range value that tells a trader indeed about a trend being reversed or not. This is why average true range readings shall always be compared with earlier readings in order to understand a trend’s behavior.
The average true range is never able to measure the direction of the currency’s prices and only measures the volatility. Only knowing the volatility can sometimes send mixed signals, especially during pivoting market trends. To take an example, a sudden average true range increase due to a significant move can lead to traders thinking that the average true range confirms the old trend, which may not be absolutely true.
The average true range is a beneficial method to understand exit and entry points for every Forex trader. The average true range should always be used with a solid trading strategy that will help the trader determine suitable trades.
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