Use ATR to Project Profit and Manage Risk

Professional traders rely on a mix of mathematics, fundamentals and logic to design strategies, and they have research departments and economists to guide them as well. Fundamentals move markets, but when the fundamentals are lacking traders rely on their technical tools.

Fundamental Dimensions

During MTM’s Daily Edge sessions each afternoon, we track momentum or directional bias and speed for stocks, ETFs and futures. Speed and direction are essential elements when designing strategy. Counter trading trend strategies work best when the pace of a move is well above the norm. My go-to tool for gauging speed is elementary and logical. Average True Range (ATR) is ideal for determining if a market is overbought/oversold. My simple rule is that if a market moves 175% of the average range for any period of time it is likely to enter a holding pattern. 

For example, if a day range spans 175% of a benchmark average day range, it is thought to have traveled too far and fast. Thus, odds favor 2 to 3 of days of sideways trade where time decay (theta) becomes the dominant factor. Premium decays when prices stagnate. If a market moves 175% of an average week over 5 sessions it will likely enter a consolidation for a couple of weeks. Vertical measurements are speedometers.

The other fundamental dimension is time at price or the horizontal element. The time spent in a consolidation phase such as a channel often has a direct relationship to length of the vertical move when the pattern is violated. 

For example, say a market has been consolidating for a couple of weeks with day ranges and volume that have been below average. As time passes, odds increase for a breakout or onset of a trend. The more time at price the bigger the breakout is apt to be. Think of it as pent-up energy. If the bottom of a flag (channel) formation is breached, long puts and bearish spreads should pay. Long calls or bullish spreads should pay if a critical resistance area is penetrated.

Use ATR to Set Targets

Once a trend begins, traders want to know how long the move will last, both in time and distance. I frequently use ATR to set targets over various time frames.

For example, assume a market has had similar and below average ranges for a five-day stretch. Imagine the market broke through a resistance level. When a breakout signal is realized the first target (T1) is the length of an average day. When T1 is reached, move risk (stop loss) to entry. With this strategy you will scratch the trade for no loss if the trend does not materialize.

If the trend does continue to extend to the second target (T2), which is set at the length of average week range from entry. When that price trades, risk goes to T1. Using this method, one may lock in profits as the trend extends. Each market has its own traits, and this management technique is ideal for locking in profits as the trend extends.

These are my benchmark ATRs:

14 days
9 weeks
7 months
5 quarters

Find time for research to create your own spreadsheet of average ranges of your favorite stocks or commodities. A good trader prepares and has pertinent data available to set risk and targets immediately after a position has been entered.

John Seguin, Market Taker Mentoring

Trader Education