Let’s use the Average True Range (ATR) indicator:
Why? Because (A) it’s a very helpful indicator, and (B) not a large percentage of forex traders use it, which means that using it will give you an edge that the majority of traders don’t have. Any way you can get an edge in forex trading will improve your probability of success (i.e., making MONEY!).
The ATR is a volatility measure and trading range indicator, sort of like Bollinger Bands are, only better, so forget about Bollinger Bands now – I was just trying to give you some frame of reference for understanding what type of indicator the ATR is.
The ATR was developed by famed technical chartist, Welles Wilder, so that’s a point in its favor right there. I’m pretty sure old Welles made some money in the markets. He originally developed it for use in commodity trading (the forex market as we know it today didn’t even exist at the time), but it’s been adopted by a number of smart forex traders because the forex market, just like the commodities market, tends to be more volatile on a day in and day out basis than stock trading usually is.
The ATR is calculated by comparing three values – the current high minus the current low price, the current high minus the previous closing candlestick price, and the current low minus the previous closing candlestick price. I’m not going to go into detail about how to calculate it because since it’s a freely available MT4 indicator, you don’t have to calculate it – all you have to do is load the indicator on your chart. It appears as a single line, in a separate window below the main chart area, and shows the range of values on the right hand side – if you just move your cursor to any point on the line, it should show you the ATR value for that point in time. And hey, you can usually “guesstimate” the ATR value with just a quick glance at it.
The ATR moves between value points – in the case of forex trading, that’s pip values, so an ATR reading of 29 translates as 29 pips. It’s especially helpful in picking take profit exit points for trades, although it can also be used to help identify entry points and stop loss placements as well.
Using the ATR:
So what can you do with this thing anyway?
Well, first of all it’s an excellent indicator of just what its name says – the Average True Range of trading over whatever time frame you apply it to. It gives a solid indication of what the average trading range currently is for the hourly, daily, 30 minute or whatever time frame you choose. Secondly, it provides an indication of whether the average trading range is narrowing or increasing. Very narrow trading ranges over an extended period of time often proceed strong, extended moves in one direction or the other, up or down.
Let’s take a look at an example of using the ATR in actual trading. Check out the chart below, an hourly chart of Eur/Usd. I’ve got a couple of simple moving averages plotted on the chart, and the ATR indicator appears as a blue line in the window below the chart.
Look At the Trade Setup:
First, I want to draw your attention to an area around the middle of the chart, several candlesticks past where trading makes a short-term low, where I’ve marked one point on the chart with a thumbs up above the current candlesticks and then another point around 20 or so candlesticks later where trading takes another dip, just before surging sharply higher, that I’ve marked with a thumbs down below the candlesticks. At both those points the ATR indicator is about mid-way between the two values shown on the right hand side of the ATR window – 9 and 37 – so the ATR at each of those points is approximately 23.
Now here’s what I’d like to point out: Let’s say you decided to buy Eur/Usd at the close – around 1.1180 – of the blue up candle that’s directly below the thumbs up sign, based on the crossover of the shorter term moving average line (green line) moving above the longer term moving average line (red line). Let’s further assume that you’re not going to be greedy in this trade, you’re only going to shoot for a profit equal to approximately 2-3 times the ATR – in other words, about the highest level you could reasonably expect the market to trade to within the next 2-3 hours, which is a little less than half a trading session, based on its recent ATR. So you put a take profit target in somewhere around 1.1240.
Okay, now where do you put your stop? Well, many traders would place it at or just below the low of that blue candle that they entered the trade on. So let’s just go with that for now. I’m not saying it’s a great idea – I’m just saying let’s use it for the moment.
Now let’s watch the action unfold. Initially the market moves up a bit, but then it just sort of stalls out for several hours. You’re not getting hurt in the trade, but the market isn’t moving appreciably higher toward your very reasonable take profit point either. Then it gets interesting…but not really in a good way. The market begins to slide down. And where does it slide down to? – JUST below the low of that blue candle you entered the trade on. Stopped out for a small loss. Now here’s the part where you want to shoot yourself: Right after stopping you out, the market decides to zoom higher, taking off to where it would have easily hit your take profit target. So it turned out that your small loss could have easily been about a 60-pip winner in just a couple of more hours…if you just hadn’t gotten stopped out.
Jeez, I hate it when that happens.
There is a Better way:
Unfortunately, it happens all too often. What I want you to take away from this little illustration is the idea that maybe you want to think about using a new system to figure out where to put stops. Fortunately, the ATR can help you out with that, since it’s not only useful for setting take profit targets, but also for determining truly reasonable places to put a stop loss order.
You’re in luck – Winners Edge Trading has devised its own unique indicator that will instantly show you ideal take profit and stop loss points on any time frame you care to trade on, based on the ATR indicator. You can check it out here, in this special report.
Best wishes, happy trading.
- J.B. Maverick
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