Introduction to True Range
True Range (TR) is a fundamental concept in technical analysis that measures the volatility of an asset by evaluating the range of price movement within a given time period. It was introduced by J. Welles Wilder in his book New Concepts in Technical Trading Systems (1978). True Range is primarily used to assess market volatility and forms the basis for indicators like the Average True Range (ATR).
Understanding the Role of True Range in Trading
Since True Range reflects price volatility, traders can use it to:
- Identify potential entry and exit points.
- Adjust stop-loss and take-profit levels.
- Develop volatility-based trading strategies.
- Filter trade signals for better accuracy.
Trading Strategies Using True Range
1. ATR-Based Stop-Loss and Take-Profit Placement
One of the simplest ways to use True Range is by employing the Average True Range (ATR) to determine stop-loss and take-profit levels. The ATR smooths the True Range values over a specific period (commonly 14 days) to measure average volatility.
Strategy:
- Calculate the ATR value.
- Set stop-loss at 1.5x ATR below the entry price for long trades and above the entry price for short trades.
- Set take-profit at 2x ATR or based on risk-reward preference.
Example: If ATR = 1.5 and you enter a long trade at $100, your stop-loss should be placed at $97.75 ($100 – 1.5 * 1.5) and take-profit at $103 ($100 + 2 * 1.5).
2. ATR Volatility Breakout Strategy
This strategy uses sudden spikes in ATR to identify breakout opportunities.
Strategy:
- Monitor ATR; if ATR spikes above its recent average, it indicates increased volatility.
- Enter a trade in the direction of the breakout.
- Use ATR-based stop-loss and profit targets.
Example: A stock trading in a range suddenly breaks out with ATR spiking above its 20-day average. This signals a strong trend initiation, prompting traders to enter in the breakout direction.
3. ATR Bands for Trend Identification
ATR Bands are similar to Bollinger Bands but use ATR instead of standard deviation.
Strategy:
- Calculate a moving average (e.g., 20-period EMA).
- Set upper and lower bands using ATR (e.g., 2x ATR above and below EMA).
- Buy when price touches the lower band and rebounds.
- Sell when price touches the upper band and reverses.
Example: If a stock is trading at $50 with an ATR of $2 and a 20-period EMA of $48, the ATR bands would be $44 and $52. A reversal from the lower band signals a potential buy.
4. ATR Trend Confirmation with Moving Averages
Using ATR alongside moving averages helps confirm strong trends.
Strategy:
- Use a fast-moving average (e.g., 9-period EMA) and a slow-moving average (e.g., 21-period EMA).
- If ATR is rising when the 9 EMA crosses above the 21 EMA, it confirms a strong uptrend.
- If ATR is falling despite the crossover, avoid the trade.
Example: A trader sees a bullish crossover on a 9/21 EMA setup but waits for ATR to rise before entering to confirm volatility supports the trend.
5. ATR-Based Mean Reversion Strategy
This strategy works best in range-bound markets.
Strategy:
- Identify assets with high ATR readings that are overextended.
- Look for price reaching extreme ATR-based levels (e.g., 2.5x ATR above or below a moving average).
- Enter trades in the opposite direction expecting a pullback.
Example: If a stock with ATR of 1.5 moves 4 ATR above a moving average, it’s likely overextended. Traders can short expecting a reversion.
6. ATR Expansion for Trend Trading
Traders use ATR expansion to identify the start of a new trend.
Strategy:
- Monitor ATR; a sudden expansion suggests a new trend.
- Enter in the direction of price momentum.
- Use ATR-based trailing stops.
Example: If a stock trading at low volatility suddenly shows a surge in ATR and breaks out above resistance, traders take long positions.
Conclusion
True Range is a powerful tool for traders looking to measure volatility and refine their trading strategies. Whether using ATR for stop-loss placement, volatility breakouts, or mean reversion, incorporating True Range into your trading plan can significantly improve decision-making. By combining ATR with other indicators like moving averages and price action, traders can develop robust strategies that adapt to different market conditions.