**Measuring Risk in the Markets with The Average True Range**

Before placing any trade, you should know your risk point. We have all heard this many times over. Know your risk or it will ruin you. The big question is how do you determine risk. One of the easiest way to measure risk is to use the ATR.

What is the risk of any market on a given day? The answer to this question is not a difficult as it may seem. The risk on any given day is the range of the day. The range represents the amount that the market moved. The range can be in your favor, or against you. If you are long you want the range to be higher than the previous day. On some days there will be a large range and on some days there will be a small range. Markets very rarely have the exact same ranges over a period of days. If you look at the range as risk, then you can determine that risk is variable.

Using the range to set stops will keep you close to how the market is acting. If the range is large, then you will need to use a greater stop. A small range would show that the market is not moving that quickly and a smaller stop could be used. We have found that averaging the range out over a period of days gives us a picture as to how the market is acting most recently.

**How to calculate the Average True Range (ATR)?**

First you must calculate the True Range for the market.

The True Range is the maximum of yesterdays range to todays range. This can be found from three simple calculations; you will take the maximum of these numbers.

The distance from todays high to todays low

The distance from yesterdays close to todays high

The distance from yesterdays close to todays low

Here is an example:

Day Open High Low Close

(Yesterday) 215.5 217.5 215.5 216.5

(Today) 216.0 219.0 214.0 215.0

Checking the distance from yesterdays high (217.5) to todays low (214) yields 3.5 points.

Checking the distance from todays high (219) to yesterdays low (215.5) yields 3.5 points.

Checking the distance from todays high (219) to todays low (214) yields 5 points.

What does this measure tell us? It tells us the maximum distance that this market traveled over a 24-hour period. The maximum risk for this 24-hour period was 5 points in this particular market. This calculation is called the True Range.

We will average this result over a set period of days, 10 perhaps. We will assign more weight to most recent time period.

Example:

Day True Range Weighting Factor ATR Value

1 5.50 1.00 5.50

2 4.75 1.00 4.75

3 5.75 1.00 5.75

4 6.50 1.00 6.50

5 4.50 1.00 4.50

6 4.50 1.00 4.50

7 4.25 1.00 4.25

8 6.00 1.00 6.00

9 5.75 1.125 6.47

10 6.25 1.125 7.03

ATR 5.30 5.45

Using this method of figuring the value of the Average True Range we are favoring the last 20% of the sample period by assigning it a higher weighting factor. Typically one can use a 12.5% weighting factor to the last 20% of the sample period.

Why do we do this? Look at the example above. Just the average of the True Range is 5.30 points. The ATR Value is 5.45. Notice the progression of True Ranges over the sample period. The last two days that were sampled had a higher True Range than the previous days. The market was experiencing a higher degree of volatility over these two days. Since the ATR really measures risk, we would like to be aware of any sudden increases in risk for a market. Weighting the ATR gives you a better idea of what is happening now or the estimated risk for this market.

Normally traders will use a 2 times the ATR for their stop placement. In our example this would be a stop of (5.45 * 2) 10.9 points. This is done to give the market some room, to ensure that you are not stopped out too prematurely.

As your ATR value increases or decreases, you can move your stop accordingly. Some traders trail their ATR stop behind their position. They adjust their stop with each move in their favor and keep the stop the same for each move against them. The ultimate decision on how to use the ATR is up to you. However, you now know that the ATR is an invaluable resource for traders.