Practical Uses for Average True Range
Average True Range (ATR) is one of the most practical indicators and can be used in many ways. Some of the ways I employ ATR is to compare recent ranges with longer-term or benchmark averages. In this way I can judge whether current volatility is high or low. Spreads tend to pay off when current ATRs are lower than the long-term ones.
Another use for ATR is to set profit targets. Prior to breakouts or acute vertical moves markets will often go through a series of days and even weeks with below average ranges and volume. These congestion patterns often take the shape of a rectangle (flag) or a pennant (triangle).
I believe the time it takes to develop these patterns may be directly related to the length of the breakout. For example, if a flag or channel pattern is 5-to-7-day longs and the upper barrier is breached the rally should extend about the length of an average week range. Theoretically, the longer it takes for a pattern to take shape the farther the trend will extend.
The moment a position is taken the next move should be to set a physical or at least mental stop loss. Trading is tough enough, so setting a stop loss may relieve anxiety, which allows the trader to concentrate on profit potential and trade management. Risk varies for all traders and may differ due to time frame of trade, account size, lack of conviction or fundamental factors such as earnings or economic reports. There are seemingly countless factors that can affect a trade.
The art of defining risk should include current volatility.
I refer to recent ATRs and percentages of them to project profit potential and risk. They allow me to be consistent with risk/reward ratios. For benchmark averages I use 14-day, 9-week, 7-month and 5-quarter. A speculator or swing trader should focus on day and week ATRs. If you prefer longer-term trades use month and quarter ATRs to set risk and profit targets. One method I implement upon entering a speculative long position is to set a stop loss at 25% of an average day range below entry and set the first target at 50% of an average day range above entry.
Hand with chalk is drawing Risk and reward balance scale on the chalkboard.[/caption]
The Workhorse and Racehorse System
I call this 2-unit system the workhorse and racehorse. Let’s walk through the steps for managing risk for a bullish swing trade. When a bullish breakout is identified go long 2 units. A unit may be any number, but units must have equal amounts.
For this example:
- Buy 1 contract for the workhorse (WH) and 1 for the racehorse (RH) at $1000
- Average day range (ADR) = $40, average week range (AWR) = $100
- Long 2 @ $1000
- Entry price plus 0.5 average day range (ADR) equals Target 1 (T1) or $1020
- Risk/stop loss is set at entry minus 50% ADR or $980
- If T1 is reached, sell 1 unit (workhorse) for $20 profit, then move stop to entry
- Now only the racehorse is active; if prices reverse to entry this unit will be a scratch trade
- If T2 (100% ADR) is reached, move stop to T1 ($1020) to lock in another $20 profit if price reverses
- If target 3 (T3 = 75% of AWR or $1075) is reached, risk moves to T2 ($1040); at this point total unrealized profit is $60
- If T4 = 100% AWR or $1100 is realized, stop moves to 25% of an ADR or $1090
- Assume this trade gets stopped after T4 was hit: WH +$20, RH +$90 for total of $110
The Goal for Swing Trades
T4 is the goal for my swing trades and that equates to an average week range. I recommend squeezing my stop at this point because the goal has been reached and I prefer to retain more profit from the high-water mark.
Senior Technical Analyst
Market Taker Mentoring, Inc.