Bulletin 13 Average True Range (3rd Article)

The Traderclub Forum: Traders Club Bulletins: Bulletin 13 Average True Range (3rd Article)

David Elden (Admin) on Thursday, February 11, 1999 - 10:18 pm:

Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 13 Nov. 4, 1998

Average True Range

This is the third 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 Bulletin #12 we showed some
specific examples of how using ATR can help to make our systems more robust. In this Bulletin we will show some of our favorite applications of ATR as part of our entry logic.

Sample Applications of ATR as an entry tool:

Entry Setups: (Remember, entry setups tell us when a possible trade is near.
Entry triggers tell us to do the trade now.)

Range contraction setup: Many technicians have observed that big moves often emerge from quiet sideways markets. These quiet periods can be detected quite easily by comparing a short period ATR with a longer period ATR. For example if the 10 bar ATR is only .75 or less of the 50 period ATR it would indicate that the market has been unusually quiet lately. This can be a setup condition that tells us an important entry is near.

Range expansion setup: Many technicians believe that unusually high volatility means that a sustainable trend is underway. Range expansion periods are just the opposite of the range contraction periods. Range expansion
periods can be measured by requiring that the 10 bar ATR be some amount greater than the 50 period ATR. For example the 10 bar ATR must be 1.25 or more times the 50 period ATR.

If you are concerned about the apparent contradiction of these two theories we could easily combine them. We could require that a period of low volatility be followed by a period of unusually high volatility before looking for our entry.

Dip or rally setup: Lets assume that we want to buy a market only after a dip or sell it only after a rally. We could tell our system to prepare for a buy entry whenever the price is 3 ATRs or more lower than it was five days ago. Our setup to sell on a rally would be that we want to sell short only when the price is 3 ATRs or more higher than it was five days ago. The choice of 3 ATRs and five days is simply an example and isnít necessarily a recommended choice of parameters. You will have to figure out the proper parameters on your own depending on the unique requirements of your particular system.

Entry Triggers:

Volatility Breakout: This theory assumes that a sudden large move in one direction indicates that a trend in the direction of the breakout has begun. Normally the entry rule goes something like this: Buy on a stop if the price rises 2 ATRs from yesterdayís close. Or sell short on a stop if the price declines 2 ATRs from the previous close. The general concept here is that on a normal day the price will only rise or fall 1 ATR or less from the previous close. Rising or falling 2 ATRs is an unusual occurrence and indicates that something out of the ordinary has influenced the prices to cause the breakout. The inference is that whatever caused this breakout has major importance and a new trend is beginning.

Some volatility systems operate by measuring the breakout in points rather than units of ATR. For example the system may require that the Yen must rise 250 points from the previous close to signal a breakout to the upside. Systems measuring points rather than units of ATR may need frequent reoptimization to stay in tune with current market conditions. However, breakouts measured in units of ATR should not require reoptimization because, as we previously explained, the ATR value contracts and expands with changing market conditions.

Change in direction trigger: Lets assume that we want to buy a dip in a rising market. We combine the dip or rally setup described above with an entry trigger that tells us the dip or rally may be over and the primary trend is resuming.

The series of rules might read something like this: If the close today is 2.0 ATRs greater than the 40 day moving average (this condition establishes that the long term trend is still up) and the close today is 2 ATRs or more below the close seven days ago (this condition establishes that we are presently in a dip within the uptrend) then buy tomorrow if the price rises 0.8 ATRs above todays low. This entry trigger shows that we have rallied significantly from a recent low and that the dip is probably over. As we enter the trade the prices are again moving in the direction of the major trend.

As you can see, the ATR can be a most valuable tool for designing logical entries. In our next article we will discuss using ATR in our exit strategies and give some interesting examples.

Attention MetaStock users

We are making plans to support MetaStock and provide our systems in MetaStock format as well as TradeStation. We will announce when this is available.

Iíll be seeing many of you at the TAG conference in Las Vegas later this month. If any of you would like to make an appointment for a consulting conference please send me a message. We offer help in solving your systems
trading problems (system logic, not programming) on an hourly fee basis.

Respond to Chuck@traderclub.com or traderclub@aol.com


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Good luck and good trading