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.



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.



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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