By Don Dawson, Online Trading Academy Commodity Futures Instructor
Average True Range is another tool I have in my toolbox for trading. Having different tools available to you will allow for making adjustments to your trading strategy as the market conditions change. There are hundreds of tools and studies one can apply to their trading strategies. I don't recommend you have so many that you become paralyzed when it comes time to pull the trigger for entering or exiting a trade. Markets do change and we must adapt when they do. Knowing how and when to use particular tools can help increase your edge over the general trading public. Most all trading platforms have this study built in so we do not have to calculate it by hand anymore, thereby reducing the chance for errors.
Let's discuss what Average True Range (ATR) is and how we calculate the study. The ATR is the average of the true range for a given period.
The true range is the greatest of the following:
- The difference between the current high and the current low
- The difference between the current high and the previous close in the event of a gap
- The difference between the current low and the previous close in the event of a gap
ATR can then be calculated by taking an average of the true ranges over a fixed number of previous periods of data. The key is to use a variable that is not too short or too long. I have found that using a number between 9 -14 works well with a fair amount of sample points. I only use the Daily bar chart to come up with the ATR for the markets I trade, not an intra-day chart (5, 15, 60 minute, etc).
This ATR is simply telling us how much a Futures contract has moved either up or down on average over the defined period we choose. When you see high levels, the study is telling us that price ranges are getting larger and more volatility can be expected. When you see low levels, the study is telling us that price ranges are getting smaller and we can expect less volatility. An observation I have seen is that in Bear markets we tend to see much higher levels of ATR due to the fear that is in the markets. Bull markets tend to create complacency and the fear level subsides causing the volatility to reduce. So while Mr. Cramer is always looking for a Bull market somewhere, we as traders should be looking for Bear markets to take advantage of the added volatility that leads to more opportunities. Below is a Daily chart of the E-mini S&P with a 10 period ATR study and what the study looks like on the chart.
Figure 1
So now we have the ATR value but how do we use it to project daily highs and lows?
I will illustrate in the chart below how I use ATR during the trading day. You can use this study with either the day session only prices or the 24 hour Globex prices. I use the Globex prices myself.
- As the Regular Trading session starts at 9:30 EST, identify the Globex High and Low up to the open.
- At that point we will take the High of the Globex session and subtract the ATR. On this particular day, the ATR for the previous 10 days was 16.50 points. The Globex high was 1034.25 minus the ATR of 16.50 equals 1017.75. This now gives us a projected low of the anticipated range today. We do the same to find the projected high. The Globex low was 1024.25 plus the ATR of 16.50 points equals 1040.75. (see chart below)
Figure 2
3. On this day the market made a minimal new low under the Globex low and then rallied. Once this rally started, you must recalculate the Projected High for the day. Remember, we are trying to identify the anticipated High to Low range for the day so you must use the current High and Low for this calculation. You add the ATR of 16.50 points to this new low to come up with the new Projected High. In this case, the Low was 1023.00 plus the ATR of 16.50 points and your new Projected High will be 1039.50. In this case, we rallied right to this level. (see chart below)
Figure 3
Keep in mind we do not use one tool to make decisions in our trading. We must use these tools in conjunction with other technical analysis tools. For example, would I take a short position in this market just because it reached my Projected High of the Day? Of course not. Here are a couple of ideas on how I would use this tool to help me decide on a trade:
- I would look left on my chart for a Support/Resistance level that was in confluence of this Projected High or Low. This would help validate that level since the market has traveled its average daily range and is now sitting at a Support/Resistance level
- If the market was at a Floor Traders Pivot level at the same time we were at a Projected High/Low, it would be a good reason to take a trade
- If I were swing trading and the market has had a countertrend move of the direction I wanted to enter a trade, I would also consider this as an overbought/oversold level to enter my swing trade
Since most of my trading is intra-day swing trading, I find this tool very helpful when I get a signal later in the day. I first look to see how big the range is so far for the day. Then I look to see if there is enough reward left in the move compared to my risk. For example, if I get a buy signal and I am risking 2 points and the Projected High of the day is only 1 point away, I will pass on that trade. This particular trade would have an upside-down risk/reward in my opinion. You would be risking 2 points to make a possible 1 point. I really like this ATR study because it keeps me from buying into Resistance and selling into Support.
As with any tool or strategy, this is not the Holy Grail. But if you think about the logic behind this study that over the last several days on average we have moved X points, we could safely assume that unless some shocking market news comes along, we should anticipate that this range will remain relatively consistent. On days where the market has a large impulse wave through our Projected High or Low, you can use this level to enter the market on a pullback – remember old support/resistance reverses roles. At a minimum, you could expect the market to return to the recent previous swing high or low for a target after you enter on this pullback.
I recently found this quote that I hope will remind you that you cannot win if you don't play.
"I can accept failure, but I can't accept not trying" - Michael Jordan
- Don Dawson
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