If you are using the trading range as an indication for future price movements, switching to the average true range can greatly help you make more accurate predictions, win more of your trades, and make more money.
As an alert student of technical analysis, you probably have heard the term average true range by now. On the other hand, you probably encountered many concepts that focused on the trading range without the using the “true” in their name. This begs the question how these two concepts differ, and which one is better suited for which trading style. To answer these questions, this article will explain the concept of the trading range in comparison to the concept of average true range.
The trading range is one of the earliest indicators many traders use to recognize a weakening or strengthening movement and to determine the momentum a trend has left. In short, the trading range is the span from a period’s high to the period’s low.
If the trading range widens and the closing price does not move too far from the period’s extreme, a movement is generally considered to become stronger. If the trading range gets narrower, the movement is weakening.
The simplicity of this rule might seem so appealing to you that you do not understand why there is any need to modify the trading range rule to generate a true range. To understand why this need is well justified, think of one of the most significant market indications that is completely unaccounted for when using the regular trading range: Gaps.
Since any trading range based calculation focuses exclusively on the distance between the high and the low of a period, it ignores gaps and therefore a sometimes significant part of the market’s total movement. To incorporate gaps into the calculation, traders designed the true range concept.
Instead of measuring the difference between the high and the low of the current period, the true range measures the difference between the close of the last period and the high of the current period after an upwards gap and the difference between the close of the last period and the low of the current period after a downwards gap.
The reason for this type of measuring is that range measurements usually do not care how the price moved. Therefore, it makes no difference whether the market moved a certain price range with the opening price of a period or moved the same price during the period. The only important measurement is the total price movement of a period, and that starts right after the close of the last period.
You can interpret the true range the same way you can interpret the regular trading range: Changing trading ranges indicate changing market conditions and thereby alert you to investment opportunities. A widening range indicates a strengthening movement, while a contracting range indicates a weakening movement.
The difference between both concepts, however, is that the true range is mathematically far more exact. Therefore, you should use the regular trading range when analyzing market movements visually or on the go. It is not as accurate as the true range, but it will greatly help you make quick decisions. As a binary options trader that focuses on short term price movements, gaps will not occur too frequently anyway.
When you are using a mechanical trading system, when you are making detailed calculations, or when you are using technical indicators, on the other hand, you should use the true range. This way, you can generate more exact results than by using the regular trading range.