How to Use the Average True Range to improve your trading results
Have you ever noticed how you can be right about the direction of a trade, but fail to make a profit?
That’s because your stop-loss levels are hit before the market could rally in your direction.
This is due to misplaced stop-loss levels and stop levels that are too close to the current market action.
So what can you do about it?
Well, firstly, understand that stop-loss levels should be based on volatility.
This gives you the greatest chance to avoid the market noise and take advantage of bigger price movements.
So, the first thing to do is to know how to maximise profits with volatility-based stop-losses, which you can do with the Average True Range indicator.
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What is the Average True Range (ATR) indicator?
Welles Wilder developed the Average True Range indicator – known as ATR, to visualise the volatility of a financial asset – whether it is a currency pair, a stock, a CFD or commodities – over a given period of time.
It’s all about understanding how and how much the price of an asset has been moving over time to better set up protective orders, such as stop-losses as well as take-profits.
How is the ATR indicator calculated?
The calculation of the indicator is based on the True Range that is usually the current high less the current low.
When there are gaps, other computations can be used such as the absolute value of the current high less previous close, or of the current low less previous close.
An average is then applied on the true range to provide the line of the ATR indicator.
What are the optimal settings?
14 is the default parameter of this indicator.
If you use the ATR on a daily chart, it shows you how prices have been evolving within the last 14 days.
On a weekly chart, it shows how prices have been evolving within the last 14 weeks and so on.
Of course, as with most indicators, you can change the initial parameters.
However, you should be sure it will have a positive impact on your trading results, as changing the ATR settings will modify its sensitivity.
If you choose a lower figure, then there will be less data used in the calculation of the indicator, so it will be more sensitive to recent price action, and the line will be choppier.
On the other hand, a higher parameter will provide a smoother line.
To be sure to use the best parameters for your trading style and strategy, it would be best to enter a series of trades with the initial and changed parameters.
Then, write down the results in your trading journal, and compare the performances afterwards to keep the most profitable.
How to use ATR to improve your trading?
The ATR indicator shows you how volatile an asset has been, so then you can predict how far the price can go upward or downward.
This will allow you to place your stop-loss and take-profit orders accordingly.
Let’s say that you are trading the EUR/USD.
The ATR line usually appears below your chart as a line that shows the changes in the price volatility of this currency pair.
The ATR doesn’t give any indication about the direction of the EUR/USD’s trend – it only helps you to anticipate how far prices have been going on average.
When the ATR line goes up, then it means the volatility on the EUR/USD increases, while when the line goes down, it shows that there is a smaller amount of volatility.
If the ATR indicates 0.0101, then it would mean that the EUR/USD has moved 101 PIPs per day on average over the last X period of days.
Using a trailing stop loss with the ATR
Most people will place their trailing stop loss two or three times the ATR reading.
So if you were trading the EUR/USD long, then your stop would sit two times 101 pips or 202pips away (2 times ATR).
The closer your stop to the average daily movement, the greater the chance you will be stopped out.
This is one of the most important aspects of the ATR indicator.
By using it, you understand and accept there will be some noise against the main trend you are trading, but you want your stop-loss to be kept out of this noise.
You can then hold your position longer and give your trading a better chance to be profitable.
Remember that the best traders are profitable over the long term because they know how essential it is to cut their losses short and to let their profits run.
Using initial protective stop-losses is an important part many traders underestimate, as they spend more time looking for the perfect entry levels without thinking about having a sound exit plan.
How to scale into winning positions to boost your trade
Scaling into a winning Forex trade could boost your profitability and can be a critical part of your trading strategy.
The idea behind scaling into a winning position is to capture more profit.
And this could be made possible by increasing the volume of a position when it is already profitable.
Scaling into winning positions can be applied whether you’re trading forex, CFDs, commodities, indices or other trading instruments.
You can think about it as a reversed martingale system.
A martingale strategy means you are increasing the size of your position when you are losing.
Scaling is applied today with great success by both novice and professional traders.
You will also find the most popular scaling strategy is called pyramiding or adding to winning positions.
Principle behind scaling into winning trades
The principle of scaling says if the price goes in the right direction, you should increase the volume by opening new positions in the same direction.
There are two ways to make it work. You can start with a full position and then add to it. Or you can open each trade with say half your normal size and then once it moves in your favour, add the other half.
Then, you will have to check in which direction the price goes.
If it goes in your direction, then you may open more positions and reap the benefits.
Let’s check an example since it can easily clarify this process.
As you can see in the chart above, the EUR/USD shows an uptrend. Initially, we don’t know where the price will go, but we have opened a long position of 1 mini contract.
After the price touched a local resistance and started to move upwards sharply, we decided to open the second position (2) by adding another mini contract.
Adjusting your stop-loss level as you scale into position
Meanwhile, we moved the stop-loss of the first position in the profitable zone.
As the price continues its move in our direction, we open a third position (3) and add another mini contract.
Immediately, we move up the stop-loss on our collective positions to the new, higher level.
Should the trade continue higher, we can add a fourth mini contract.
Keep in mind you should move the stop-losses each time on the collective position.
Why you need to scale into a position?
So, why would you need to scale your position?
Well, the answer is obvious – this is a great position sizing method in which you can maximise your profits on excellent trending moves.
But as you can imagine, there is a limit to the number of times you can add to a winning position.
There are also other techniques on how to scale into a position.
Some traders like to add to the winning trade just once but double the size of their second position. So if their first trade were one mini contract, they would add two mini contracts to the second position.
Then no more additional positions even if the trade continues in their direction.
It is worth mentioning that scaling in or pyramiding strategy should be based on technical analysis.
This is because there may be some sudden events of fundamental nature that can take the markets by surprise.
In all other instances, traders should be focused on the price action performance and keep their eyes on the chart.
Important things to consider before scaling in a trading position
- You should correctly calculate how many positions you can open simultaneously to have enough funds.
- It would be ideal to increase the position two or three times and then return to the original level. The trend cannot go on forever, and this approach will minimise the loss in case of a reversal.
- The great about pyramiding is you only add to winning positions. In theory, you will not be adding to a sideways moving market or a down trending.
Considering the benefits of scaling into winning trades, it will be worth including it in your overall trading strategy.
Test it on your previous 20 completed trades and see if the results would have improved.