Reasons Why the Average True Range (ATR) is Crucial in your Forex Trading

To use indicators or not to use indicators? This question refers to the opening phrase “to be, or not to be…” in Shakespeare’s famous play of Hamlet.

Many traders do opt for trading “naked” and solely using price action (momentum) and/or candle sticks for their trading decisions. Other traders wind up employing over a dozen indicators or more when making their trading conclusions (causing paralysis of analysis).

First of all, Winners Edge Trading recommends keeping trading simple. That means that over-combining too many indicators is just not effective and efficient.

Secondly, some indicators have more value for certain types of strategies, and hence using a few indicators when used properly and within the TOFTEM model actually improves a trader’s decision capabilities.

The decision of which indicators to actually use and which ones to skip is not an easy path. There are tons of indicators available and even more so created each week. How does a trader even start the process of evaluating each and every one?

It is a daunting Hercules task.

But there is good news too… Winners Edge Trading is here to help!

We highly recommend using a simple tool called the ATR – Average True Range.

2- 1- 2015 atr

AVERAGE TRUE RANGE (ATR)

For a clear explanation of what the ATR is and how it is calculated, I would recommend to read and review this link. It explains the basics about its composition so I will not repeat those lessons here but instead dive into why and how using the ATR is beneficial for your trading.

The ATR is one of those rare indicators that you always want to have on the chart because it provides vital information about the probability and likelihood of the market approaching or hitting your exits – which is either stop loss or take profit.

Knowing if your exit is within the market’s range is important information because ultimately the exit of a trade will determine whether a trade is a profit or a loss – not the entry. Winners Edge has written several blog posts on the topic before such as:

  • Avoiding early exits is easier than Forex traders think;
  • 2 methods for improving FX exits;
  • This particular post is focusing on the benefit of ATR for the exit decision.

ATR WHEN DETERMINING EXITS

Traders tend to use a wide variety of tools and indicators for determining exits but one thing that they often do not use is this:

  • An indicator which identifies whether a target is realistically in reach;
  • An indicator which identifies whether a stop loss is realistically out of reach;
  • An indicator which identifies whether a trail stop loss has a chance of (safely) being moved without putting it in needlessly in harm’s way.

The ATR does all of the above.

The ATR indicates the average range of the recent history and a trade can thereby judge whether the target is within the average of the recent history or outside of that zone.

The following conclusions can be made:

  • Stop loss is within ATR level – DANGER: stop loss is too close to price action and trade has too high chance of hitting the stop loss;
  • Stop loss is outside of ATR level – GOOD: stop loss is far away from price action and trade has a decent change of not hitting the stop loss;
  • Target is within ATR level – GOOD: take profit or soft target is close to price action and trade has a good chance of hitting that zone;
  • Target is outside of ATR level – DANGER: take profit is too far away from price action and trade does not have a decent change of not hitting the target zone.

2- 1- 2015 atr 2

SIMPLE CONCLUSION

With the above ideas in mind the conclusion becomes very simple:

To improve your exits keep your targets within the average range and keep your stop loss outside of it.

Not many indicators can actually help assist a trader in recognizing that a target or a stop loss is in or out of a range. The simplest way of doing so is using the ATR.

THE SPECIFICS/WHAT RANGE

Winners Edge Trading recommends using an ATR with a value of 20.

When setting up the stop loss, Winners Edge Trading recommends using 7 up 12 value of ATR. This means that a trader must take the ATR value of the entry candle and multiply it anywhere from 7 till 12. By doing this, a trader knows that they are not placing the protective stop in the middle of price action.

When setting up the take profit, Winners Edge Trading recommends using 4 up 8 value of ATR. This means that a trader must take the ATR value of the entry candle and multiply it anywhere from 4 till 8. By doing this a trader knows that they are placing the target in the middle of price action.

WHY VARIANCE IN THE LEVELS (4 TO 8 & 7 TO 12)

There is perhaps a considerable gap between 7 and 12 for the stop loss and 4 and 8 for the target and you might wonder why. The market is not a rigid structure and is very dynamic. In our testing all of these levels actually work well. Therefore we rather decide the multiply level for each individual trade. How do we do that?

We use the market structure on a higher time frame to choose the best stop loss and take profit levels within the recommended zone. Because the entire zone is good, we can use our discretion within that zone to optimize our results. What I mean is that a trader can use 4-hour and/or daily tops and bottoms for placing stop losses above resistance or below support; where placing targets below resistance and above support for further refinement of their edge.

What do you think of the ATR?

Can you imagine how the above tactics could help improve your trading?

There are traders who point to reward to risk ratio that potentially is lower than 1:1 should be aware that the reward to risk ratio is only half of the story. Win percentage is just as important. Find more info on system expectancy here.

Thanks for sharing and Happy Hunting!

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Winners Edge Trading was founded in 2009 and is working to create the most current and useful Forex information and training available on the internet.

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  • Chris

    Hi Georgi, most welcome! Not an easy one to judge as I have never used this technique. I could imagine that adding pips to the previous day high and low via the ATR value could make sense. Its not clear to me how it would be used for taking trades… but I can imagine its use for taking profit or placing stop losses.

  • Georgi Venkov

    10x for ur answer. i will implement the atr in my trading.
    recently read another article for atr, basically sayng this:
    atr 20, daily
    taking 50% of the sum high+low atr
    on 4h chart, add the pips from the above point over prev daily close
    on 4 h chart subst pips from prev daily close
    this range is the most likely for the day

    for example 100 pips over and 100 pips below prev day close
    follow the price movement
    no big news or data
    if pair moved already for ex 80 pips in the above or bottom part of range, it will remain there, because it is most likely to move arround another 20-30 pips or so

    this combined with stoch for overbought or overselled pair
    makes sence, but this way a lot of the movement will be lost

    haw can you comment this?

  • Chris

    Hi Georgi, thanks for the feedback and comment! Glad you find the post helpful. Yes the reward to risk ratio is not going to be very high, but it will be compensated by a higher win percentage. It should be noted though that you do not want to aim for 4x TP and have 12x SL because then the R:R is too low (0.33:1). So you want to keep a balance there. Anything from 0.5 or higher is ok. Preferably though we aim for 0.6 as the minimum. If you get close to the 1:1, the better it is. In some cases we even go above 1:1 because we enter at a discount compared to our trigger, so then we might a TP of 9x ATR (instead of 6) and a SL of 7x ATR (instead of 10), making it 1.28 R:R instead of 0.6.

  • Georgi Venkov

    hi Chris, and 10x for the article.
    the levels you suggest to apply for tp and sl are a bit strange to me: if i understand correctly, the trader following 4-7 for tp and 7-12 for sl will have poor rr ratio, or at best 1:1 if multiply atr x 7 for tp and atr x 7 for sl /which will lead to the same pips though and sl will be in the range…
    do i get it right, and if so isn’t this a way for taking more risk for sl in a trade?
    i do like the tp option within the atr range /explained perfectly in the article/, but the sl is just too far, meaning if smtg goes wrong the account will suffer big time

    10x in advance for ur answer