Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 11 Oct. 28, 1998
Average True Range
This is the second in a series of articles about using Average True Range. In our first article in Bulletin 10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In this article we will show some
specific examples of how using ATR can help to make our systems more robust.
First lets look at a simple buy only system for Corn without using ATR. Here are the rules:
1. Buy Corn whenever it rises 4 cents per bushel from the opening price.
2. Take a profit whenever the profit reaches 18 cents per bushel.
3. Take a loss whenever the loss reaches 6 cents per bushel.
Now lets build the same system using ATR. (Assume that the 20 day ATR is 6 cents).
1. Buy when the price rises 0.666 ATRs from the open.
2. Take a profit when the profit reaches 3 ATRs.
3. Take a loss whenever the loss reaches 1 ATR.
We have the original system and a modified version that has substituted ATR for the important variables. The two systems appear to be almost identical at this point. They both will enter and exit at the same prices. Now let's
assume that the market conditions change and the Corn market becomes twice as volatile so that the ATR is now 12 cents per day instead of 6 cents. Here is a comparison of the original system and the ATR system:
1. The original entry of 4 cents per bushel from the open is now too sensitive. It will generate too many entry signals since the daily range is now 12 cents instead of only six cents.
However, the entry expressed as 0.666 ATRs will adjust automatically and will now require the price to move 8 cents per bushel to enter. The frequency and reliability of our entries remains the same as before.
2. The original profit objective of 18 cents per bushel is much too close for a market that is now moving 12 cents per day. As a result the profits will be taken too quickly and our original system will be missing many opportunities
to make much bigger profits than usual.
However the profit target expressed as 3 ATRs has automatically expanded the profit objective per trade to 36 cents per bushel. Significantly larger profits are now being realized by the ATR system as a result of the increased
3. The original stop loss of 6 cents per bushel will now be hit frequently in a market that is moving 12 cents per day. If you combine these frequent stop loss exits with the overly frequent entries being generated, you have a classic “whipsaw” situation and we can expect to encounter a severe string of losses. Our original system is now failing because the market conditions have changed. We need to fix it or abandon it in a hurry.
However lets look at our ATR version of the system. The stop loss expressed as 1 ATR now sets our stop farther away at 12 cents so it isn’t being hit any more frequently than before. We continue to have the same percentage of winning trades only the winning trades are much larger than before thanks to an increased profit objective. Our ATR system has a nice series of unusually large winning trades and is currently making a new equity peak. The ATR system now looks better than ever.
In our example, the proper application of ATR has made the difference between success and failure.
In our next bulletin we will look at a few more of the many ways we can apply ATR in our trading systems.
I will be speaking about ATR at the 20th Annual TAG conference in Las Vegas November 21st, 22nd, and 23rd. For information about the TAG conference (highly recommended) visit their web page at http:// www. telerateseminars.com
As previously announced I recently spoke at Dr. Van Tharp’s workshop for Advanced System Development. As always his workshop was well attended with a broad cross section of traders ranging from nearly new beginners to experienced floor traders and hedge fund managers trading millions of dollars. Dr. Tharp’s new book Trade Your Way to Financial Freedom is now available and I recommend it highly. It may be hard to take a book with such a title
seriously but I can assure you the book is much better than the title would lead you to believe. This book contains some very sound and insightful material that should be welcomed by serious traders regardless of their methodology. I think that you will find Van’s work on money management, or “position sizing” as he prefers to call it, particularly valuable. The book was published by McGraw Hill and is not yet available in local bookstores. I’m sure you can obtain it from Dr. Tharp by visiting his website at http://www.iitm.com/ or order it from my old friend Ed Dobson at Traders Press
(phone 1 800 927-8222) or go to http://www.traderspress.com/
Good luck and good trading