Some people love charts. For them, charts are a way to forecast the future. By looking at cycles from the past, it can help them project what might happen into the future.
Yet other people simply loathe them. They see charting as gibberish, representing no more than someone’s subjective squiggles.
To those against them, if charts show anything at all, it is that hindsight is a wonderful thing. Wouldn’t it be great to trade the left-hand side of your screen?
Whether you are a devotee of technical analysis (TA), agnostic about it, or simply refuse to acknowledge any merit in it at all, it can still help with your trading.
Too often the whole TA debate centres on predicting price movements. After all, that is the aim of trading: To sell at a higher price than bought.
If you bog yourself down in this one aspect of TA though, you will get nowhere. Even the staunchest defenders of TA will have plenty of trades that don’t work out. And those who are against TA have to accept there are trades where TA has worked.
What is important is the percentages. That is, the times it works in their favour…and the average return they make on each trade.
But predicting price movement is just one aspect of TA. There are plenty of signals that can help you. Not only to better understand the market, but how to manage your trades.
Take one of the most basic indicators, the average true range.
No doubt most investors are familiar with a daily price range. That is, the difference between a share price’s high and low on any given day.
While it gives a true indication of that day, it might not accurately reflect the real range of a share price. Particularly if the price gaps from one day to the next.
Because of that, TA uses a ‘true’ range, which includes the previous day’s closing price.
If yesterday’s close is somewhere in between today’s high and low, then it is no big deal. Today’s daily range is also the true range.
However, if yesterday’s close is above or below today’s range, then it becomes a factor in the calculation. The true range becomes the difference between yesterday’s close, and today’s high or low — whichever is greater.
The average true range is just as extension of this. As the name implies, it is an average of this true range — not just an average of daily price ranges — over a period of time, which is usually 14 days.
ATR can be a great way to gauge volatility in a share price and more broadly in the market. If the ATR is increasing it shows that volatility is on the rise.
While there is no hard and fast rule, an increase in volatility can sometimes lead to a change in direction. That is, the last price gyrations as momentum runs out.
Using ATR to gauge volatility can also help with those who use options. Higher volatility means higher option premiums, while lower volatility means lower premiums.
Because of that, those who want to buy options aim to do so in periods of low volatility. Those that write options — that is, whose initial trade is to sell an option — want to capture this higher volatility. For them it means more premium in their trading account.
However, ATR has wider uses beyond option premiums. You can use ATR as a signal to both enter and exit trades.
If, for example, a share price jumps above the ATR, a short-term trader might decide to hold back on going long. All else being equal, it means they could be paying too much — or beyond the odds, so to speak — to get into the trade.
Conversely, a breakout trader might use this exact same scenario to enter a long trade. That is, they buy when the share price breaks out of its existing range. Whatever their overall strategy, the ATR can play a vital part.
As I mentioned, ATRs can also be useful in working out when to exit a trade. A day trader might aim to enter in the lower part of the ATR, and exit when the share price reaches the upper end of that range.
Similarly, they might short sell in the upper range, aiming to buy it back in the lower end of the ATR.
Where an ATR can be really useful, though, is with an exit stop. If the ATR gives an indication of the likely share price swings, a trader can place their stop-loss based on a multiple of this. For example, a stop-loss, say two or three times the ATR, below their entry price.
This should give the trade enough room to move, but also indicate (if struck) that the initial analysis for the trade was wrong.
The good thing about an ATR stop is that it more accurately reflects the state of the share price (and market), because it accounts for volatility. That is unlike the more widely-used fixed price stops, or percentage-based stop, which do not.
Accounting for this volatility can help place your stop-losses in better positions.
Maybe you already use TA…or perhaps you haven’t had any inclination to use it at all, so far. But by using indicators like the ATR, it might help you improve your trading results.
All the best,
Editor, Options Trader