27 May Why The Average True Range Indicator Made Me A Better Day Trader
In this post I’ll explain what the average true range indicator is, for what purposes you can use it and how you can implement it. This indicator is especially important for those who have a small account and are trading regular stocks ($10+ stocks).
My Introduction to the average true range indicator
If you’ve read any of my posts you know that I take trading very seriously. It’s possible to earn a lot of money in a short period of time but I don’t see it as ”fast money”.
I look at trading the same way as a heart surgeon looks at his profession. He looks at it like something that deserves a lot of devotion, time and effort.
Having said that, it shouldn’t come as a surprise that I’ve read a lot about trading before entering my first serious trade. ( I bought some stock when I was 14 but that was just childs play)
One of those books talked about the Average true range indicator and how it could help set profit/stop-loss targets. Because I already tackled those pieces of the puzzle I didn’t gave it much attention until a later moment.
That moment came when I looked at my equity curve and I was going absolutely crazy from frustration. You might ask yourself why?
Well, I was improving on a consistent basis but once in a while I had an ”annihilation day”. What I mean by that is that I lost my weekly profits in just 1 day.
So my equity curve looked something similar to this:
What was going wrong?
So I tried to think of what was going wrong but I couldn’t come up with an immediate answer. I was good at cutting losses quickly 95% of the time but sometimes I really sucked at it.
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And when I did suck at it, I sucked at it on a massive scale.
So what was happening here?
Instead of thinking about it I made the decision to start analysing all my statistics. Maybe I could find some clues there?
The first thing that I looked at was the holding time of those big losers. I compared them to the holding time of my small losers and guess what?
It would be quite logic to assume that my holding time was probably much longer, right?
Yes, but surprisingly that wasn’t the case at all. The holding time of those big losers was about the same as my small losers.
Then it hit me.
God damn, that average true range indicator.
What is the average true range indicator?
Basically the average true range indicator shows you the range of a stock. It shows you the minimum and maximum move of a stock within a specific period.
As I mentioned earlier, this can help you with setting profit/stop-loss targets but that’s not all. I use the average true range indicator to determine which stocks are easy to manage when it comes to losses.
Think about it.
Lets say that the 1 minute range of a stock lies somewhere between 1 and 2 dollar. That indicates that the stock, on average, makes moves of 1 to 2 dollar in any given minute.
If we divide 2 dollars / 60 seconds, it would equal to a move of 0,033 cents per second. That might not look much to you as your reading this now but it’s pretty fast in real life.
A stock with an ATR of 1 to 2 dollar per minute can hit your stop-loss before you know it. At least assuming that you’re using a tight stop-loss of 25 cents or less.
If you’re using a mental stop-loss it can be difficult to cap your loss at 25 cent per share. Those stocks move so fast that you can have an unrealized loss of 50 cent + within a few seconds.
And what will you do if that happens?
Will you pull the plug even while the unrealized loss is twice the size of your max loss? Or will you be tempted to give the stock a few seconds hoping to decrease your unrealized loss?
If you give that stock a few seconds, your loss might grow even bigger. At some point you’ll have to pull the plug otherwise you might end with huge losses, just like me.
I traded stocks that moved so fast I didn’t had a proper change to cap my loss early enough. My unrealized loss would grow 4 to 6 times as big as my intended maximum loss within seconds.
At that point it was even more difficult to cut my losses but luckily I did.
If you don’t, you’ll probably blow up your entire account instead of having a big loss. Taking a big loss is much better than blowing up your account.
Always keep that in the back of your mind if you’re having trouble to realize a big loss.
Why did it make me a better trader
The average true range indicator made me a better trader because I can actively avoid stocks that move to fast and therefore manage my losses much better.
It does still happen sometimes that my loss is a little bit bigger than my max loss but I’m talking about 1 to 5 cents more. Those numbers are not a problem at all and are easy to recover from.
So basically this was one piece of the puzzle for me! My equity curve looks a lot better since I’m using this indicator.
How to set up this average true range indicator
If your broker has it and you know how to implement indicators you can find it by searching for average true range or ATR.
If your broker doesn’t have it or you don’t know how to implement an indicator you can send them an email. Hopefully they will help you out.
In case that doesn’t work out, you can always use tradingview. Tradingview offers free and premium charting software and this indicator is available with both.
To do so, you can follow the instructions below:
Go to tradingview.com and search for a specific stock.
Then you click on interactive chart.
Next you’ll need to click on indicators at the top of the page, search for ATR and click on Average true range.
Finally it will look like this:
Looking at the ATR of TESLA on the 5 minute chart you can see that it’s range is between 0,40 cents and approximately 1,25 dollar.
So this basically means that you can expect that tesla makes moves between 40 cents and 1,25 each 5 minutes.
One of the most important rules in trading is that you need to keep your losses very small.
So you MUST exit your trade when it reaches your maximum loss target. However you must be able to sell it quickly enough to actually keep your loss below or at that maximum loss level.
If your maximum loss is 25 cent per share and you’re in a stock that moves 1 to 2 dollars within a minute it’s very likely you won’t have enough time.
Before you know it you’re well over your maximum loss of 25 cents per share and you have an unrealized loss of for example 50 cents +.
So in order to manage your losses well you shouldn’t trade stocks that move to fast for your account size/max loss.
Because I don’t know how big your account is, it’s difficult for me to say what’s to fast for you. This requires a little bit of experimenting from your side.
Keep a close eye on all the trades you make. If you feel like some stocks move to quickly and don’t give you enough time to cap your loss, check their average true range.
Do this a couple of times and then determine what kind of ATR levels you should avoid and use that as a filter criteria when you’re creating your watch list.