average true range Archives - Algorithmic and Mechanical Forex Strategies

Oscillators you need to use

May 31, 2016 by Lior Alkalay 8 Comments

Oscillators, one of the most interesting groupings of technical indicators, are designed to signal overbought and oversold levels. Oscillators are a family of indices that go beyond the mathematics. They focus on one important thing and that is momentum, or more specifically changing momentum. Before we delve into which Oscillators are best to use and how, let me save you some unnecessary pain. Let me tell you first what oscillators aren’t.

How Not to use Oscillators

Some traders believe that Oscillators are some sort of magic indexes. Rest assured when I tell you they are not. Oscillators’ main use is not to tell you whether to buy or sell. Rather, they alert you to when it might be a good time to execute a buy or sell strategy. That is a very big difference. Those who attempt to use Oscillators as an ultimate buy or sell signal should be ready to learn a tough lesson. Those that will use it to fine tune their timing, however, will find Oscillators a very powerful tool.

Now that we’ve established what oscillators are good for let’s focus on which oscillators are worth your time and how to use them.

MACD Indicator

Perhaps the most widely used Oscillator in Forex, the MACD needs no special introduction. What it does need is a proper explanation of how to use it and when.

The idea of MACD is to signal your entry point when you’ve already figured out where the trend is going. It’s not going to alert you to a trend. What that means is that you first have to perform your technical analysis. Once you reach a conclusion, then you can use the MACD.

On MT4, the MACD comes with default parameters (12, 26, 9). 12 represents the fast Exponential moving average, 26 the slow exponential moving average and 9 the Simple MACD average. Usually, when you trade on a daily basis, those parameters are fine.

Now in the chart below we see two points, A and B. In point A, the histogram moved above the average and that is supposed to be a buy signal. But, technical common sense says that a pronged bearish trend cannot end abruptly without some form of double bottom. Hence, one should ignore that signal.

But in point B, that’s a different story. After a double top that hits a resistance level and hits the trend average, there’s a case for a short. But we need to know when. Notice how after the second top the histogram in the MACD falls again below the average? That’s our mark and that is how you use MACD to time your trade. Once again, the lesson here is that Oscillators are for timing, not for point to the pair’s direction.

Stochastic Oscillator

This is one of the most interesting indicators in the Oscillators family. What I like about this indicator is that it essentially gives you a 2-dimensional picture of overbought, oversold and momentum. Unlike the MACD, that’s not always accurate on overbought/oversold level.

The idea of the stochastic oscillator is twofold. First, it’s normalized from 0 to 100, anything below 20 is oversold and anything above 80 is overbought.

Second, using the convergence between the %K line and the %D line tells you something. Not only can you tell when there is an overbought/oversold level but also when the trend turns bullish or bearish. Thus it affords a 2-dimensional use of momentum. Confused? Here’s a classic example of how I would use a stochastic oscillator.

In the first part, we can see that in point C, after the pair has bottomed, the stochastic oscillator was below 20. That signaled an oversold level. We can conclude that there the pair is bottomed out, through a double bottom pattern. We can use the oversold level as enforcement but wait before dipping our toes into a buy position. Only in point D, as the blue line crosses the red line, we get our signal for entry.

However, one other thing is important to note and that is point E. In point E we get the blue line crossing the red line as it does with C. However, since the cross occurs very close to the overbought signal that should deter us from establishing it as an entry. Which means if the crossing in point D was close to the stochastic 80 level, we should have avoided entry.

Average True Range

Last but not least, one of my favorite indicators, the Average True Range or ATR for short. Unlike the other two Oscillators the ATR is useful in anticipating potential rises or falls in volatility. Also unlike the other two, there is no oversold or overbought levels. If the ATR is high it suggests volatility is high. Conversely, if the ATR is low it suggests volatility is low.

How can we use this to predict volatility? We know, of course, that volatility is cyclical. Thus we can assume that when the ATR is at record lows for a prolonged period (point F) it’s a signal that a spike in volatility is coming. And, indeed, we can see volatility did come and we got the big spike.

If we decide to use the support as an entry signal we can ATR to gauge whether there’s a chance our buy trade will have a strong momentum. If the ATR was at a record high when we decide to buy that would have been a cautionary note. Not to entry but because it signals that volatility might fall and that means momentum might have been weak. The same principle, of course, works for a sell signal.

Fade Range Reversals For Rich Rewards

September 5, 2014 by Eddie Flower 16 Comments

Fading range reversals is a powerful forex trading strategy. This “fading” strategy capitalizes on markets’ tendency to revert back toward their mean values in time. It relies on simple rules, and there’s plenty of room for adjusting it to fit any market.

Range reversal signals rely on input from earlier-opening markets, which can provide the set-ups for successful trades later during the global business day.

Forex traders often watch the range of a currency pair’s price for clues as to expected price movements during a later-opening marketplace, and the possibility of tradable price reversals.

Two of the most effective reversal indicators are the average daily range (ADR) and the average true range (ATR). They can be used together or separately to signal trading opportunities from range reversals.

Range reversal opportunities

Many experienced traders have noted a tendency for the major currency pairs to reach their intra-session maximums during the New York session. This session is pivotal for the sizes of ranges to be achieved in other sessions.

As well, all markets on opening at least acknowledge the last prices of earlier markets

So, it makes sense to develop mechanical trading systems to harvest gains from these fairly predictable phenomena. Expert advisors (EA) and mechanical trading systems can often find price levels where a currency pair is likely to reach the extent of its range, before moving back inside that range.

The best-designed systems focus on finding high-probability set-ups where the price is likely to complete its range move after the markets open in New York.

Below, I’ve outlined my fading range-reversal forex strategy, which lets me harness the power of probability and the law of reversion-to-mean for profitable trading.

“Reversion to mean” means predictable gains

The range reversal strategy is based on the concept of reversion to mean, which is also sometimes called regression toward the mean.

In financial markets, this concept refers to the mathematical law which says that if a price is extreme during one or a few measurements, that price will tend to be found closer to the average price once subsequent additional measurements are made.

In other words, anytime you see a price outside its normal nearby range it will usually quickly return to a level within that range. Over time, prices tend to return to the average over the entire set of data.

So, with regard to the range reversal strategy, the forex trading system assumes that during each individual trading session or shorter time-frame, a currency pair’s price move will become exhausted at a certain “average” point. At that point, the price will probably reverse and return back within the limits of its average daily range.

My range reversal trading strategy is focused on fading the daily momentum in anticipation that the price is expected to regress toward its mean, that is, move back toward its average range.

Average daily range & average true range

Even in spite of volatility, currency pair prices generally move with a fairly predictable range each session. Under typical market conditions, a price moves around a range calculation called the average daily range (ADR).

The average daily range (ADR) is simply the average of the daily price range calculated for a given number of days.

The average true range (ATR) is a bit more discriminatory of price range during gap-ups or gap-downs. The ATR is calculated as the greatest value of the following:

• Current high minus current low
• Absolute value of current high minus the previous close
• Absolute value of current low minus previous close

The ATR represents a moving average (usually a 14-day MA) of the individual true ranges.

The benefits of using ATR & ADR

The value of these daily range indicators is that they show the volatility of the currency price and also indicate likely reversal points. When the range increases, it shows the price is volatile.

The range reversal strategy works well when both indicators are employed, since the ADR provides a baseline and the ATR accounts for gap-price volatility.

ADR and ATR are easily determined by mechanical trading systems; the most popular time periods are 5, 10, or 20 days. After determining the typical ranges for the targeted currency pairs, the system looks at the day’s open for a given time frame, say from midnight, and then calculates the target price area for trading signals.

For example, let’s use EUR-USD with an ADR indicator, and assume an opening at 12 a.m. ET at a price of 1.2300. The strategy allows the price to make its primary move from 12 a.m. to 5 a.m. ET. During this time period, the price typically sets up or forms the “high” and “low” for the day.

The session opened at midnight ET at 1.2880. Next, as the London session opened, the price dropped to a low 1.2788 before again moving back upward to 1.2811 just before the opening of the New York session.

First, determine support and resistance

During the New York session the trading system automatically looks for support if the price keeps moving downward, or for resistance if price moves strongly upward. Let’s assume that the ADR is calculated as 120 pips.

So, the EUR-USD pair should find support near 1.2760. In this case, the ADR is calculated by subtracting the daily session high minus the daily session low.

On the other hand, if the low price at 1.2788 is sustained and the euro enjoys plenty of buying during the New York session and moves still higher, then the probable next resistance will be around the 1.2910 level.

The system calculates this number by taking the day’s low and adding the Average Daily Range (120 pips in this example) onto it. In either case, the trading system signals support and resistance levels during the New York session.

Find support and resistance levels for the next-highest time-frames

After the trading system determines where the price is located in relation to the ADR, the next step is to find the support/resistance levels calculated for each of the next-highest time-frames, which are typically 1-hour or 4-hour time-frames.

Often, there is plenty of support/resistance in targeted areas, and trading signals should be confirmed by using multiple indicators. Many different technical tools could be used, but Fibonacci retracements and extensions, pivot points, and retracements are some of the best.

Above is a 4-hour chart. You’ll see there’s significant resistance around 1.2910. From a technical viewpoint, this shows the previous high swing on the 4-hour chart, and in the left area you’ll see there’s been strong support during a period of several days. The green boxes show a number of faltered attempts by price to move outside the target area.

For the downside, in this case the 1.2760 price level is at or near the trading system’s calculated value for a 50% Fibonacci retracement of the last swing from the 4-hour time-frame. This move is significant. This level may act as support, or the price may break through this level.

Once the price breaks through that level, it should then act as support if the EUR-USD continues to move downward during the remainder of the New York session. In fact, it can be seen that the 1.2760 level has been an area of price support before.

The trading plan

The trading system has confirmed support around 1.2760 as well as resistance around the 1.2910 level.

When the price begins its move toward one of these two levels during the New York session, the system is standing by, ready to “fade” the session’s momentum and ride the currency pair’s price back into its average daily range or average true range.

The overall goal is to find situations in which momentum has built up, then capitalize on the residual momentum to ride the price back toward its range for a fair profit.

As mentioned earlier, the range reversal is a mean-reversion strategy. In the chart below are some examples of where to apply this strategy, and what to avoid.

The range reversal strategy takes advantage of the probability that, as the price exhausts the movement of its daily range, it will reverse and return back into or toward the ADR in a show of reversion to the mean price.

Even while expanding its range intra-session, the price tends to reverse itself at some point and move back toward one end of the range before resuming its move toward the other extreme.

The trading system relies on a variety of tools to determine support-resistance, including Fibonacci indicators. The system identifies the reversal point, usually at a recent strong resistance or support level.

Fading the range reversal

When the currency pair’s price reaches that reversal point, the system enters a trade which “fades” the price move. It’s expected that the price will return back inside the daily range, or perhaps expand to fill it.

Fading means trading against the current trend, with the expectation that the price will return to its normal daily range. This is a contrarian strategy, since the trading system sells when the price is rising and buys when the price is dropping.

The chart above illustrates three scenarios: The first situation shows a high-likelihood set-up, then the next two situations represent trading signals that should be screened to improve the trading system’s performance.

It’s been said that a range expansion is a very clear signal the market will soon move in the direction of the expansion

In the first situation shown in the chart above, the Euro first became stronger during the Asian session, then the price reversed from support levels of the previous, all just prior to the opening of the London session. At that point the ADR indicator began rising, which signals a range expansion.

During the London session, the price added 55 pips, which is far short of its average daily range of 120, which lays out the scenario for the upcoming opening of the New York session. By adjusting these values, the trading system improves its success rate through better set-ups.

The successful range reversal trade features these elements – A reversal from a support or resistance level, a range expansion, the trend wave is pointing upward, and there’s a tradable opportunity in the remaining average daily range.

The range reversal strategy doesn’t always work, as shown by the last two example set-ups in the chart. In the second scenario, the Euro’s price continued upward, but then reversed strongly during the London session, when it over-ran its ATR by 60 pips. The trading in New York was flat.

In the third set-up shown, the advantage of a mechanical trading system is that it should screen this signal and avoid the trade based on the fact that the force of the move has already been spent. There’s not enough trading activity to repeat the previous performance.

Screening range reversal signals

As seen on the chart, when the minimum and maximum values of the ATR (ADR) are very close together, it indicates that volatility has been exhausted, and trading activity needs time to rest.

Because of the risks from holding “fade” positions during reversing markets, the range reversal strategy favors quick-in, quick-out trading methods. Since the trading system has already pre-calculated the average true range, the rate of momentum, and the amount left for potential gains, the profit expectations must be tailored to fit the marketplace.

Also, it’s important that the trading system screen and reject any trades that are signaled if (1) the price’s average daily range has already been surpassed during the London session, or (2) the signal was generated when volatility reached exceptionally high and low levels during a very short period of time.

Entries

The entry points are determined based on the key resistance and support levels, plus Fibonacci levels. And, the ADR or ATR indicators are assessed in view of the range for the London session.

Returning now to dissect the trading opportunity in the first scenario shown on the above chart, it helps to take a look at the price under a microscope, by using a 15-minute chart, as shown below.

Again, the focus is to adjust the trading system according to what may happen during the New York trading session. In this example, the price momentum began in London, and all indicators suggested that the price move would continue once the New York market opened.

The trading system chooses an entry point just after the typical profit-taking on any positive run-up, which usually happens just before New York opens.

The system can calculate a stop-loss order to meet precise needs for risk management. The typical stop-loss amount is usually 25 or 30 pips.

Range reversal profit-taking

Using a 2 x 1 reward-to-risk ratio calculated based on the stop-loss, the profit targets should be set at a minimum twice the stop-loss amount. It’s best when the stop-loss amount is near the projected upper limit of the ADR or ATR.

It’s important not to become greedy when using the range reversal strategy. Patience is also necessary, since it may take some time to fine-tune the trading system for shorter time-frames.

Keep in mind that there are other trading systems using similar strategies, so it’s always best to get in and out of the trade quickly, before the market sentiment changes. Be happy with a fifty- or sixty-pip gain.

Find range reversals and fade them for profits

You’ll be surprised at how often range reversal trading set-ups occur, yet you’ll need to use the appropriate complementary indicators to screen the signals and confirm your likelihood of success before entering a trade.

Also make sure to apply the principles carefully so your trading system is programmed to reject any trades signaled by the two exceptions to the rules mentioned again here:

Avoid the trade if the price’s average daily range has already been exceeded in the London session, and also reject any signal generated when volatility has reached high and low levels within a very short time.

With tight risk management and fine-tuning, your trading system can profitably trade range reversals on a regular basis, even under fairly volatile market conditions.

A Home On The Range

August 21, 2014 by Eddie Flower Leave a Comment

Trading ranges and range breakouts offer some of the most common and potentially most-profitable marketplace scenarios encountered by forex traders. Yet, many traders are unable to build a winning strategy to profit from trading price ranges and breakouts.

The secret to successful range trading lies in identifying trading ranges and breakouts as early as possible, and then trading them proactively before the herd comes in and drives the price too far in either direction.

By using the right tools, ranges and breakouts are fairly easy to spot and take advantage of. Ranges offer something for everyone: Range traders work to trade currencies while prices remain within the range, and breakout traders focus on entering positions when the currency pair’s price leaves the range.

Properly traded ranges can be very profitable – When breakouts occur, they can yield huge returns. Meanwhile, range-bound forex trading strategies offer a slow, steady way to accumulate gains.

Still, it’s critically important to trade carefully: The keys to success are to avoid trading false breakouts and corrections, manage risks appropriately, and keep the expectations realistic.

In this article, I’ll describe some ways to identify and confirm stable trading ranges, which can then be successfully exploited by mechanical trading systems using a wide variety of strategies.

What’s a trading range?

The term “range” refers to the difference between the high and low prices for a given currency pair during a given time-frame. Range is the price spread during the time-frame, and it also represents the volatility of the currency.

The more volatile a currency price is, the wider its range. Obviously, the longer the time-frame, the wider the observed price range. For mechanical trading systems, ranges are useful for determining technical support and resistance levels as well as setting entry and exit orders.

Likewise, range is a measure of risk – The wider the range, especially during short time-frames, the riskier the currency play. By choosing the right trading strategy and employing appropriate risk-management measures, a forex trader can harness the power of the range to achieve excellent gains.

A trading range or channel occurs when a forex price trades at or near the same price over a period of time. When the price eventually moves outside this range, it’s called a breakout.

Breakouts from a range

Breakouts indicate momentum, whether positive or negative, in the sense that the balance of power of “long” and “short” currency holders has shifted to the opposite side.

After a breakout, the price may either continue to move away from the range, usually very sharply up or down, or else the price may return back inside the range, signaling a false or failed breakout.

Breakout trading strategies work to capture the gains from pent-up buying or selling pressure that can explode when prices move outside their typical ranges.

It’s easy to see a breakout after it has already happened, yet the challenge for traders and mechanical systems is to identify and act on the true breakouts while avoiding the false or failed ones.

Trading systems must effectively manage entries into false breakouts, since they’re so common. After entering a trade, the price may rise quickly before suddenly retreating back toward or into the range. Successful systems choose only the most likely winning trades.

It’s important to keep in mind that about fifty percent of all breakouts from ranges will retrace all the way back to the breakout point before once again resuming their desired moves.

A well-built system should be prepared to re-enter a new trade immediately after a loser, if the price overcomes its correction before again moving in the desired direction. And, during a correction toward the breakout point, the ideal trading system should at least harvest a small gain even after giving back most of the paper profits.

The solution for these issues is to use a winning combination of signal filters and confirming indicators to screen prospective trades before entering positions. In particular, tools and indicators based on the angle of the moving-average line, MACD, Average True Range (ATR) and Standard Deviation (SD) are very helpful for these tasks.

Breakout trading

As mentioned above, the most important concept to understand when trading range breakouts is that half of all forex breakouts fail. So, the most successful strategies are based on avoiding entering trades immediately. Instead, the system checks for confirmation before entering any trade.

The trading system should be programmed to wait until the price first retraces to the breakout point, then begins to move in the favorable direction again. This confirmation helps the trader reduce losses which inevitably occur during frequent retracements.

Psychologically, these retracements are even harder for the trader to tolerate when he or she is first stopped out, then the correction ends and the favorable move resumes without him or her aboard. So, it’s important that the trading system should only enter a trade once the price re-crosses the breakout point.

Of course, a retracement to the breakout level only happens about half the time. Still, the gains from confirmed breakouts can be spectacular and the confidence of success after waiting for confirmation is much higher.

Regardless of the individual strategy used to trade the breakout, one of the most common ways to set profit-targets is by using a target price that is equal to the width of the range either added or subtracted from the breakout price.

Range-bound trading

During trends, small traders can often trade profitably simply by following the trend and riding along with the herd of major institutional players. However, in a trendless, range-bound market, traders need a different group of strategies. Under such conditions, trend-following systems may generate many false signals for trades which ultimately lose.

Trading breakouts and trends can be profitable, yet major breakouts are relatively rare. A given currency price typically spends about half its time moving in a trend, and the other half in a range. Traders who ignore range-bound plays are missing half the fun and profits.

Forex traders who seek more opportunities often develop strategies for trading currencies while their prices are stuck in ranges or channels, where they may remain for long periods of time.

Range-bound trading strategies work by identifying the price ranges or channels in which currency prices are confined. These strategies are based on the prediction that prices will stay within the range.

In the most basic scenario, a mechanical trading system determines the nearby support and resistance levels, then it buys when the price touches the bottom (support) of the range, and sells when the price reaches the top (resistance) of the channel.

“Pure” range traders don’t care whether a currency price is going up or down, as long as it develops and stays within a trading range.

The range-trader’s underlying assumption is that prices will repeatedly return back to recent levels. The goal of mechanical range-trading systems is to harvest the gains from this repetitive cycle, while fine-tuning gains and losses by analyzing and responding to the latest market data.

Instead of merely finding the best entry points, range-trading systems should also be programmed to be “wrong as early as possible” and with carefully-adjusted position sizes so that the trading capital is preserved for subsequent trades that arise during the repetitive up-and-down price cycles that characterize forex ranges.

Detecting range-bound markets

Ideally, the trading system should be configured to spot the earliest stages of range-bound markets. Of course, it’s impossible to precisely predict winning trades every time, but the earliest recognition of a range allows the most flexible trading response.

Here’s the main rule for assessing a given market:

If the market isn’t obviously trending, it should be treated as a ranging market

With regard to technical indicators, when the chosen indicators stop showing clear signs of a distinct price trend, the trading system should assume the market is entering into a new range-bound period.

One of the easiest ways to spot a range-bound market is by checking the angle of a Moving Average (MA), generally by using a Simple Moving Average (SMA). For example, if the SMA is rising quickly, then the angle of its price line compared with the time axis will become steeper.

Likewise, if the angle is becoming lower, the trend is becoming weaker. If the angle is flat or near-zero, then the market is range-bound, or very sleepy.

Trading systems can be programmed with indicators built to compare the steepness of the angle of the current SMA against its “normal” steepness during different market periods. These indicators can be set to respond with various degrees of sensitivity to changes in the moving-average angles.

Another easy way to detect ranging markets is a Moving Average Convergence/Divergence (MACD) indicator. This type of tool works well in real time, especially when markets are volatile.

By adding two levels to the indicator – lower and upper horizontal lines below and above “0” on the MACD, trading systems can spot levels at which prices are most likely to consolidate.

In the chart below, the principal ranging zone is shown inside the green box. And, inside the box I’ve highlighted the ranging areas between the 0.05 and -0.05 levels. These are the tradable areas where the trading system detects a ranging market in real time.

As well, the MACD-based range-bound zone can be adjusted to values such as 0.03 and -0.03 or another value that the trading system determines to be appropriate for a given market. An expert advisor (EA) can help define the appropriate levels by examining historical levels in particular markets.

In any case, the MACD histogram hanging around the zero level indicates a ranging, tradable market.

Although naysayers may claim that this method doesn’t show the entire range until after the sideways movement has ended, your trading system doesn’t need to wait that long. When the MACD first enters the ranging zone, you’ll have plenty of warning that a range-bound market is about to occur.

Once the MACD enters the zone, the trading system can monitor the price and use additional confirmation tools to confirm that the range is still intact before trading. This MACD-based method can be very helpful in combination with other indicators.

Using Average True Range and Standard Deviation to spot trading ranges

As indicated earlier in this article, ATR and SD are helpful in highlighting trading ranges which can be exploited.

Shown in the EUR-USD chart below are two indicators, the 14-period Average True Range and the 14-period Standard Deviation, which can be used as tools to discover potential trading range areas.

In one indicator scenario, for example, when the 14 ATR is greater than the 14 SD, it indicates a ranging market. And, when the 14 ATR is less than the 14 SD, the market is trending.

From one perspective, the apparent logic behind this indicator is that the ATR shows the shorter-term daily volatility while the SD represents volatility over a longer period of time; although the market stops trending, the intraday volatility may stay the same, or slow down even more.

In another simple strategy, the trading system can simply monitor whether both ATR and SD are pointing upward. If so, the market is trending.

Also, savvy traders can build trend-strength indicators based on calculating a rate-of-change ratio between the current ATR and SD values using the desired time-frame. These indicators are useful for showing ranges as well as breakouts.

The usual default number of periods is 14, and Fibonacci-lovers often use 21. Still, as a rule, the shorter the trading system’s time-frame, the greater the number of periods should be.

If the ratio is increasing, it means the trend is becoming stronger. Or, if it’s dropping, it means the trend is weakening and will soon become either a range or a reversal. If the ratio is at the bottom, it indicates a ranging market.

In summary, there are a variety of ways for forex traders to determine whether a market is in a range, breaking out or trending.

Regardless of the strategy employed, traders can feel right “at home on the range” once they’re able to identify ranges and thus have more opportunities to trade them.

What’s your own trading style? Are you a range trader, breakout specialist, or trend-follower?

Setting Initial Stops Using Average True Range (ATR)

April 18, 2013 by Andrew Selby 1 Comment

Getting stopped out of positions is a common occurrence for all traders. There is a sense of relief involved when a positions gets worse after your stop is triggered, but it can be incredibly frustrating to get whipsawed out of a position only to watch it rocket higher.

Accounting for volatility in your stop placements helps reduce the chance of a whipsaw trade. Fixed distance stop losses don’t bring the same advantage.

Using Average True Range (ATR) To Set Initial Stops

Average True Range (ATR) represents the average range that a market moves over a given time period. Using a multiple of ATR allows a trader to give highly volatile positions enough room to run, while at the same time making sure that low volatility positions are held tightly in check.

I typically set my initial stop 3ATRs below a new position. If that’s new lingo to you, it means that I take the ATR and multiply it by 3. If you bought LNKD at 178.66 and its ATR was 6.22, then you would set your initial stop 18.66 below you entry point, which would be 160.00 if there was no slippage. Based on your own personal risk preferences, you can use any multiple of ATR in order to take into account that market’s historical volatility.

The LinkedIn (LKND) daily chart with its average true range (ATR)

What Is Average True Range (ATR)?

The concept of Average True Range (ATR) was originally introduced by J. Welles Wilder in his 1978 book New Concepts in Technical Trading Systems. Wilder was looking for a way to describe the historic volatility he was encountering in commodities markets.

Wilder took the True Range indicator and smoothed it out using an exponential moving average. The most common time frame for ATR is 14 days.

True Range is calculated using the following formula:

true range = max[(high-low), abs(high-prevclose), abs(low-closeprev)]

By adding the second two components of this formula, Wilder was able to account for gap up and gap down situations that True Range struggled with. True Range only measures the change within a bar and not the change between two bars.

My Evolution To Using Average True Range (ATR)

When I began my trading career over a decade ago, I didn’t think I needed to bother with setting an initial stop loss. I was only going to be buying stocks that went up, so I had no reason to worry about downside risk. That was for suckers who couldn’t identify growth stocks.

Experience humbled me. I was likely to be wrong on as much as 50% of my trades. As I began to come to terms with the fact that I was not a perfect stock picker, I started to see the need to set a stop-loss order when I established a position.

My reading informed me that Livermore and Loeb recommended no more than a 10% stop. O’Neil recommended a 7-8% stop.

Since I still viewed myself as quite gifted, I figured that a 7% stop would work for me because I was only dealing with the very best stocks, and it was very uncommon for them to lose 7% from a breakout…..or so I thought.

As I continued to lose money, a very intelligent trader pointed out to me that I was not even considering the volatility of each of the stocks I was buying. Some of the stocks on my watch list would move 2-3% up or down everyday, but some of them rarely moved more than 0.5%. This explained why it felt like some of my positions had too much room and others felt way too tight. Experience taught me that looking at volatility just makes sense.

Example ATR Comparison

The chart of LNKD above showed a stock with a 6.22 ATR. As a point of comparison, here is a chart of MSFT, which has an ATR of 0.504.

Microsoft (MSFT) daily chart

Even a novice trader can see that there is a huge difference in volatility between these two stocks. Since LNKD moves with much more dollar volatility than MSFT, it will need more room to work with if you establish a position. Conversely, MSFT doesn’t need much room at all because of its low volatility history.

Using ATR For Trailing Stops

ATR extends beyond setting the initial stop loss. The indicator also works for setting trailing stops as a position becomes more profitable, such as in the RSI Trend strategy. A simple application of this is to keep the stop updated to be a mutliple of the market’s ATR below the high of the position.

Using ATR as a trailing stop can help to protect your profits, while at the same time give your position enough room to move.

Volatility & Divergence Commentary

February 17, 2012 by Shaun Overton 2 Comments

This week has been an ideas week. An unusual number of clients are asking for my opinion on the ideas that they want to program into an expert advisor. Divergence and volatility keep popping up as themes for the week.

Simple Volatility Filter

Volatility is one of those factors that you cannot ignore in trading. It highlights the overall risk context of the market and says something about the likelihood for a trade to get some wheels.

The number of tools that we have to study volatility is unfortunately very limited. Almost everyone uses ATR, which is the average true range. The calculation for it is very basic. The true range is simply the high minus the low. The ATR is simply the average of all the true ranges over a certain period. Most traders use a 14 period ATR by convention.

I sent the chart below to a client in Australia yesterday who asked if I had any ideas for a volatility filter. It compares a fast and slow volatility window using ATR. The red line represents the 14 period ATR, which I call the fast line. The blue line represents the 300 period ATR, which I call the slow line. I suggested that period he could use the fast line appearing above the slow line as an indicator of high volatility. The opposite indication would indicate low volatility.

Two ATR lines may signal a trend, although they would not indicate the direction.

I created the above chart by dragging and dropping the ATR custom indicator onto a chart. I then dragged and second ATR indicator onto the first ATR indicator. Doing that way overlaps the lines. 0therwise, you would see two lines in separate windows.

When I opened MetaTrader again this morning, the same chart was left open. I immediately noticed that the line crossings appeared to match up with some of the longer term trends. Although it would not indicate the direction of a trend, the ATR crossings might prove useful as a trend detection indicator. If you decide to research this idea, please leave your comments and observation on the blog page below. I enjoy hearing from my readers.

Divergence

I buy into the idea that the market contains price points that are more relevant than others. A lot of the math that I work with involves autocorrelation, which many refer to as the long term memory function. It’s a mathematical tool that allows nerds like myself to find hidden statistical patterns among a bunch of noise in a signal.

Divergence takes a similar idea and applies it to indicators, the most common of which are the MACD, RSI and stochastics. When the price rises above a previous critical point and the indicator does not exceed its previous critical point, then divergence exists. Most traders claim that divergence signals the potential end of a trend.

My biggest gripe with divergence is that the length of trends exhibit random periods. I’ve done plenty of independent research on this topic. Regardless of the method that you use to pick market tops and bottoms or how you define a trend, the time period of the measured trend is always random. It has a probability density, but it definitely does not have a set number.

Divergence completely fails to address this concern. There’s no reason why you can’t have 2 divergences or even 5 divergences in a trend. Divergence does not help the trader distinguish between the end of a trend or a continuing trend. You could use divergence as a trend detection tool, but by that point some traders are already calling for it to end. My personal opinion is that it’s not very useful.

My other complaint with divergence is that the method for picking critical points is totally arbitrary. If you put 10 traders in a room and ask them to draw a trend line, you will get 10 different answers. The absence of consensus on such a basic concept ought to say a great deal about the value of subjective interpretation.

Traders also attempt to draw the points between swing highs and lows. That task should be obvious, but it’s not. I always recommend using the zig zag indicator when customers want to go down the swing trading route. They quickly discover the same problem – how sensitive should the settings be. Again, we circle back to the issue of period length. The swing high that Bob’s Zig Zag settings draw looks like market noise to the swing highs that Alex draws.

My opinion is to stay away from divergence and look for other techniques.