Best Short Term Trading Strategies – ATR Calculation
How Does The ATR Indicator Work
The ATR indicator stands for Average True Range, it was one of the handful of indicators that were developed by J. Welles Wilder, and featured in his 1978 book, New Concepts in Technical Trading Systems.
Although the book was written and published before the computer age, surprisingly it has withstood the test of time and several indicators that were featured in the book remain some of the best and most popular indicators used for short term trading to this day.
One very important thing to keep in mind about the ATR indicator is that it’s not used to determine market direction in any way. The sole purpose of this indicator is to measure volatility so traders can adjust their positions, stop levels and profit targets based on increase and decrease of volatility.
The formula for the ATR is very simple: Wilder started with a concept called True Range (TR), that is defined as the greatest of the following: Method 1: Current High less the current Low Method 2: Current High less the previous Close (absolute value) Method 3: Current Low less the previous Close (absolute value) One of the reasons Wilder used one of the three formulas was to makes sure his calculations accounted for gaps.
When measuring just the difference between the high and low price, gaps are not taken into account. By using the greatest number out of the three possible calculations, Wilder made sure that the calculations accounted for gaps that occur during overnight sessions.
Keep in mind, that all technical analysis charting software has the ATR indicator build in. Therefore you won’t have to calculate anything manually yourself. However, Wilder used a 14 day period to calculate volatility; the only difference I make is use a 10 day ATR instead of the 14 day.
I find that the shorter time frame reflects better with short term trading positions. The ATR can be used intra-day for day traders, just change the 10 day to 10 bars and the indicator will calculate volatility based on the time frame you chose.
Here is an example of how the ATR looks when added to a chart. I will use the examples from yesterday so you can learn about the indicator and see how we use it at the same time.
Before I get into the analysis, let me give you the rules for the stop loss and profit target so that you can see how it looks visually. The stop loss level is 2 * 10 day ATR and the profit target is 4 * 10 day ATR.
Make Sure You Know Exactly What The 10 Day ATR Equals Before Entering The Order
Subtract The ATR From Your Actual Entry Level. This will tell you where to place your stop loss level.
In this example you can see how I calculated the profit target using the ATR.
The method is identical to calculating your stop loss levels. You simply take the ATR the day you enter the position and multiply it by 4. The best short term trading strategies have profit targets that are at least double the size of your risk.
Notice how the ATR level is now lower at 1.01, this is decline in volatility.
Don’t forget to use the original ATR level to calculate your stop loss and profit target placement. The volatility decreased and ATR went from 1.54 to 1.01. Use the original 1.54 for both calculations, the only difference is profit targets get 4 * ATR and stop loss levels get 2 * ATR.
If you are taking long positions, you need to subtract the stop loss ATR from your entry and add the ATR for your profit target. For short positions, you need to do the opposite, add the stop loss ATR to your entry and subtract the ATR from your profit target.
Please review this so that you don’t get confused when using ATR for stop loss placement and profit target placement. This concludes our three part series on the best short term trading strategies that work in the real world.