Average True Range: A Good Indicator for Emini Trading

Indicators are an alphabet soup of average, ranges and misunderstood indicators.  None are more misunderstood the Average True Range and the criticisms of this indicator are legion.  I hope I can clarify some of the problems people have with this indicator and give you a good methodology for using it properly in your emini trading.

When I am feeling particularly lazy (which is more often than I care to admit) I bracket trade the ES with 12 tick stops.  This is a system that is fairly effective and will, by and large, keep you out of harms way, but is annoying to watch the price continue upward on days when there is a high degree of volatility.  Let me ask you, don't you think there must be some way to calculate just how high, at least theoretically, a trade might go?

Average True Range was developed by J. Welles Wilder and first published in 1978.  His book "New Concepts in Technical Trading" is a veritable storehouse of information for emini traders interested in oscillators, moving averages and momentum indicators.  It is fascinating in every respect, and enlightening.  The book does not read like a novel, more like an academic paper and Wilder uses mathematical equations to explain most of what he is explaining to the reader.  But don't let that deter you, as the math is not overly complicated and following his train of thought in the equations in the book is truly a wonderful experience.

Wilder started with a concept called True Range (TR) which is defined as the greatest of the following:

1.  The current High less the current Low.
2.  The absolute value of the current High less the previous Close.
3.  The absolute value of the current Low less the previous Close.

If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, it is likely that one of the other two methods would be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move). To ensure positive numbers, absolute values were applied to differences

Typically, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first TR value in a series is simply the High minus the Low, and the first 14-day ATR is the average of the daily ATR values for the last 14 days. After that, Wilder sought to smooth the data set, by incorporating the previous period's ATR value. The second and subsequent 14-day ATR value would be calculated with the following steps:

1.  Multiply the previous 14-day ATR by 13.
2.  Add the most recent day's TR value.
3.  Divide by 14.

A careful examination of the above concepts will lead you to surmise, then, that the Average True Range is an exponential moving average that provides the trader with a good idea of the potential for movement in a trade.  So, ATR can form a good basis for calculating the potential upside of any trade, or downside.  If we know the market is oscillating wildly on a given day, you 12 tick stops my, in fact, be too tight to trade a position.  How did we know this?  Ah, the Average True Range for the day give us a clear indication of the potential swings in a given trade.  I set my stops, then, at .5 of the average true range, both long and short.  

You can keep youself from getting blown out of a trade through normal market noise, and assure yourself you are in a proper range to reap the potential of any trade.  Check it out, Average True Range will make you a better trader.