The Average True Range Indicator (ATR) is yet another trading creation by J. Wells Wilder. In his 1978 book, “New Strategies in Technical Trading Systems,” Wilder introduces the Average True Range, RSI, Directional Movement Indicator and its useful component the ADX, Parabolic SAR, and sketches out his take on Reversion to the Mean theory, among a host of other trading concepts. As I am sure you are aware, several of the important principles of modern technical trading theory are based upon Wilder’s conclusions in the book.
The ATR is used and misused for a wide variety of functions related to e-mini trading. Let’s start with an issue that makes the indicator problematic; the readings on the ATR have no direct relationship to price and give no indication of price direction. As a matter of fact, this indicator is a reasonably direct measurement of volatility. Wilder envisioned the “True Range” in absolute values to insure positive number results.
This is where “true range” theory breaks down, for some e-mini traders.
Most indicators and oscillators are a depiction, in some form, of the price (and price behavior) of a trading instrument under examination. With many indicators and oscillators, a rising line would indicate the market is going upward and vice versa for falling lines and lines moving downward. In the middle of this mass of rising or falling lines is the diminutive Average True Range, whose lines may be moving in a direction that shows only a limited correlation to the lines on the price based indicators. This paradox often causes the ATR data to be misread or misapplied when trading.
On the other hand, when used correctly the ATR can supply indispensable information. In my personal trading, I use the ATR to calculate profit targets and stop losses. In addition to indicating the volatility in the market, I assume a good part of the ATR reading (especially in channels) to be market noise. I do not want to be stopped out of a trade by a slight actual move in the market and the market noise that may be a normal component of that move. It is fairly normal for me to set my stop loss at 1.5 x ATR, and my profit target at 2.0 x ATR. This unbalanced risk /reward ratio maximizes my profit and stop/loss calculation and gives an idea of what numbers on the chart I can have a reasonable expectation of achieving. I believe this approach is logical and helps me maximize potential returns and assess risk.
The ATR has a variety of e-mini traders who employ it for less popular uses in trading. For example, I have seen traders utilize the Average True Range in actual trading. By adding the indicator value to the closing price, the trader can calculate potential breakout points on the next trading day. Similarly, potential exits can calculated by adding the ATR to the previous days close. I personally employ the ATR in my trading solely to calculate profit targets and stop loss figures.
I pay close attention to this indicator to decide if the market is too slow to trade or too volatile to trade. For example, on a particularly active trading day the ATR may climb to a reading of 20. Using the formula I outlined earlier in this article, that reading would force me to set my stop loss to 30. Depending on the contract and how well I am trading I may decide that risking 30 x #of contracts I am trading represents too great a risk for the size of my trading account. As a matter of fact, 30 almost always presents more risk than I am willing to shoulder.
In summary, the ATR is an ideal way to understand volatility in the e-mini market. Since volatility is directly related to risk, I can get a good idea where to place my stop loss point and profit targets. I mentioned some alternative uses for the Average True Range Indicator in e-mini trading, but did not overly endorse their use.
Source by David S. Adams