Average True Range is another tool that I have in my toolbox for trading.  Having different tools available allows you to make adjustments to your trading strategy as market conditions change.  There are hundreds of tools and studies that can be applied to a trading strategy.  I do not recommend that you used 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 a particular tool can help increase your edge over the general trading public.  Most trading platforms have the Average True Range study built in so we do not have to calculate it by hand, reducing the chance for errors. Let’s discuss Average True Range (ATR) and how the study is calculated.  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 is 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 and 14 works well with a fair number of sample points.  I use the daily bar chart to calculate the average true range for the markets that I trade, not an intra-day chart (5, 15, 60 minute, etc). 

ATR is simply telling us how much a futures contract has moved up or down on average over the defined period we choose.  When the ATR is high, the study is telling us that price ranges are larger and more volatility can be expected.  When the ATR value is low, the study is indicating that price ranges are 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 average true range because of the fear that is in the markets.  Bull markets tend to create complacency and fear levels subside causing the volatility to be reduced. 

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.


This is an excerpt from October 2009 issue of Trader's Journal.