Managing risk and expectations: Average True Range

TRADING always involves risks and rewards. Your position has a potential upside (it’s the reason you trade), yet to be able to take advantage of it, you need to accept some risk. One simple way to assess this is to use the Average True Range (ATR) indicator.

The indicator gives you the average range over the time frame you are trading. Say that you hold a bearish euro-dollar view. What would be a good profit target? In this case, we can consult the monthly ATR. Looking at the last six months, we can see that the average range has been 430 pips. So if we are at the beginning of the month, and think it’s time to short euro-dollar, if price declines as expected and we are up 430 pips, it would be time to book a profit.

Yet say you don’t think it’s time to short euro-dollar. You might think this week’s non-farm payrolls will disappoint and we could see a 200 pips rally, reaching $1.14. With this information, if and when we reach $1.14, we could go short. And with the help of the ATR, we would know that trading much higher than 230 pips above $1.14 would be hard. So we may go short at $1.14 with a stop at $1.1630, and if $1.14 is indeed the high of the month, we could have $1.0970 as our profit target – ie 430 pips lower.

Another way to exploit the ATR is to calculate how likely you are to get stopped out. The last 14 days ATR is 100 pips. Yet with most retail trades using a 25 pip stop, there will only be a 25 per cent chance that their position will be open 24 hours later. If you work with a 100 pips stop loss, the likelihood that the position will be open 24 hours later will theoretically be 100 per cent. With this example, we can see that being slightly longer term goes a long way.

Alejandro Zambrano is a currency strategy analyst at DailyFX.com.