By Bob Moore – The Average True Range (ATR) is not only useful in setting stop loss limits, but also is helpful in determining entry/exit points for day and swing trading.
But first, let’s review what ATR is and how it is derived. ATR is exactly what the name implies. That is, it is a numerical value that depicts the average of the true, daily range of an instrument (the range is the difference between an instrument’s high and low within one day).
Simply stated, the ATR is an average of the daily True Ranges of an instrument. The daily True Range is derived by taking the greatest of the following: 1) Difference between the High and Low for the day; 2) Difference in the day’s high and yesterday’s close, if there is a gap up at the open; and 3) Difference in the day’s low and yesterday’s close, if there is a gap down at the open.
So how is ATR useful? ATR is useful because it tells you that, on average, an instrument’s price should be trading within the Average True Range during any given day.
Setting Stop Loss Limits with ATR
When traders use Stop Loss Limits (SLL) based on the ATR, they are basically stating that they believe the instrument will not decline more than the ATR (SLL = entry price – ATR) or some percent of the ATR (SLL = entry price – ?%ATR). The amount of ATR used in the calculation is determined, in part, by your tolerance for risk. Depending on your tolerance for risk, 50% of ATR may be an appropriate stop limit for day trades, whereas 100% or more of ATR may be appropriate for longer held trades.
Determining Entry and Exit Points using ATR
Let’s consider the perspective of an S&P 500 eMini (ES) trader considering a trade near market opening on February 16, 2010. Overall Market momentum certainly appeared to be positive based on the following: 1) The S&P 500 and Nasdaq Composite were poised to penetrate their Key Resistance Levels of 1085 and 2184, respectively, indicating possible development of upward Elliott Wave 3’s (assuming the trader followed Elliott Wave patterns);
2) Short-Term Trends in most instruments had changed to Positive from Negative (assuming the trader followed Short-Term Trend analysis); and
3) A new Taylor Trading Technique 3-Day Cycle had just begun (assuming the trader followed Taylor Trading Methods).
Before placing an order, however, the trader predetermines a Stop Loss Limit. Since the trader planned to hold the position intra-day to no more than a day, a Stop Loss Limit derived from 50% Average True Range (ATR) was determined to be appropriate.
The trader assesses the appropriateness of entering the trade by assessing the likelihood of the position reaching his/her Stop Loss Limit. In the case of ES on February 16th, 50%ATR=10.75. Therefore, if the day trader entered an order at, say, 1080, then he/she would set the Stop Loss Limit at 1069.25 (1080 – 10.75). Upon review by the trader, the ES shows support at 1073.5 (Buy Day Low) and had not been at 1069.25 during the regular trading session since the week before. Therefore, there appeared to be a good chance the ES would not decline to the Stop Loss Limit considering the Market’s currently upward momentum.
The trader also predetermines when to exit the position to keep emotion (in the form of greed) out of his/her decision. Again considering ATR, the upward limit for the ES determined by ATR would be 1095 (ie, 1073.5 (day’s low) + 21.5[ATR]). The trader decides on an exit point lower than the upper limit of 1095 to increase the probability of completing the trade during the day.
The ES established a high of 1094 on February 16th and a high of 1100 on February 17th. If the trader had decided to make an intra-day trade, he/she would have made a 7-point profit (minus expenses) if he/she exited at 1087, or a 12-point profit (minus expenses) if he/she exited at 1092, both conservatively below the upward ATR limit of 1095. If the trader had decided to hold onto the trade overnight, he/she would have made an 15 point profit (minus expenses) if he/she exited at 1095, the upward ATR limit of the day before.
Either trade is a winner. And the point is to eliminate, or at least reduce, the losers, so you can keep the profits from your winners.
About the Author
Bob Moore is with Taylor Trading Plus, an international data-exchange trading service using George Taylor’s Book Method, Value Area trading, Elliott Wave analysis, and Short-Term Trend analysis to identify trading entries/exits in select instruments of Futures, ForEx, Commodities, Metals and Oil, ETF’s, and Stocks. To request chart example pertaining to this article, please go to ‘Contact’ tab at: http://www.taylortradingplus.com.
