Background: The Average True Range indicator was developed by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems. This is another measure of volatility based on price action during a given period, with a higher ATR indicating a high level of volatility and a low ATR indicating a low level of volatility.
The ATR is based on a moving average of true ranges, typically for 14 periods. True range is the greatest of:
current high less the current low.
absolute value of the current high less the previous close.
absolute value of the current low less the previous close.
Purpose: ATR was developed primarily for commodities markets to measure daily price volatility. These markets are more likely to have price gaps or limit moves, meaning that a volatility formula based on only the high-low price range would not include the effects of these gap or limit moves. ATR includes this missing volatility using absolute values but does not indicate price direction, only reflecting the degree of interest or disinterest in a move.
Basic signals: If today's high is above yesterday's high and today's low is below yesterday's low, then today's high-low price range is used as the true range (the first alternative above).
If yesterday's close is greater than today's high or is less than today's low, then it signals a gap or limit move, and one of the other alternatives apply to determine the true range to use in calculating the ATR. At the beginning, the first TR value is simply the high minus the low, and the first 14-day ATR is the average of the daily TR values for the last 14 days. After that, the data is smoothed by incorporating the previous period's ATR value.
Strong trending moves, whether up or down, often include large price ranges or large true ranges, especially at the beginning of a move. Consequently, ATR can be used to help determine the enthusiasm behind a move or provide reinforcement for acting on a breakout.
Pro/con: ATR provides a better gauge of a market's recent price range and volatility over a given period. However, for markets that trade continuously around the clock, a steady stream of prices may reduce the need for the ATR indicator. ATR also does not provide any guidance on price direction.
TWO-LEGGED PULLBACK TO MOVING AVERAGE (M2B, M2S)
By Galen Woods in Trading Setups on 14 December 2013
Read more about Moving Average, Price Action, Trading Trend
Many price action traders claim that two-legged pullbacks are the most reliable trade setups. The variant we are reviewing today is from Al Brooks, who wrote three tomes on price action trading. These three books are not an easy read, but are extremely informative for price action traders.
In his books, he identified a two-legged pullback to the moving average as one of the best trade setups when there is a strong trend.
Before we start, let’s have a basic explanation of counting legs. Any bar that goes higher than the previous bar starts a new leg up. Any bar that goes lower than the previous bar starts a new leg down.
TRADING RULES – TWO-LEGGED PULLBACK TO MA
LONG TRADING SETUP – M2B
Strong up trend
Two-legged pullback down to 20-period EMA
Enter a tick above the bar that tested the 20-period EMA
SHORT TRADING SETUP – M2S
Strong down trend
Two-legged pullback up to 20-period EMA
Enter a tick below the bar that tested the 20-period EMA
TWO-LEGGED PULLBACK TO MA TRADE EXAMPLES
WINNING TRADE – M2S
This is 5-minute chart of ES futures contract, which is the main instrument Al Brooks trades. This trade is a beautiful example of a two-legged pullback trade.
After prices crossed below the EMA, it tried to crossed back but was clearly rejected.
The strong downwards thrust confirmed the down trend, which was what we needed before looking for continuation trades.
The two short dotted lines highlight the beginning of each leg up. This two-legged pullback looked good with the long top tails that showed as prices approached the EMA. The long top tails implied selling pressure.
LOSING TRADE – M2B
Another session of S&P E-mini futures showing 5-minute bars, which is Al Brook’s recommendation as the sweet spot for day traders.
The day started with swings up and down without a clear direction. However, as prices made new lows, bottom tails emerged, showing buying pressure.
The up swing above the EMA seemed strong as there were eight consecutive bars with higher lows. However, there were three bear trend bars within the swing, which hinted at persistent bears.
Following a two-legged pullback to the EMA, we had a bullish reversal bar as our signal bar. We entered a tick above it but got stopped out after some sideways movement.
A key difference between the losing trade and the winning trade is how certain we were that the market was trending. In the winning trade example, we saw clear rejection from the EMA, which we did not see in the losing example.
REVIEW – TWO-LEGGED PULLBACK TO MA
Continuation trades work because the trend traps counter-trend traders. Two-legged pullbacks are more enticing to counter-trend traders and works better as a mousetrap for them.
Hence, in a trending market, the two-legged pullback to the moving average is a simple and high probability trading setup.
The key lies in finding trending markets. Pay attention to signs of a trending market and trade opportunities will present themselves. Very often, you can pay attention to the space between prices and the moving average for a sense of momentum. Two-legged pullbacks that follow strong momentum are better quality setups.
However, very strong trends tend to have single leg pullbacks. If you insist on waiting for two-legged pullbacks, then you must be ready to miss some trades in strong trends.
Also, with regards to counting legs of price movement, there are many nuances that we did not cover. Refer to Al Brooks’ Trading Price Action Trends: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley Trading) to learn more.