The true trading range is an improved concept to estimate the volatility of the market. Especially traders of touch options and boundary options can profit from the average true range’s ability to predict how far the market can move over the next periods.
What is the true trading range?
The true trading range is a concept to judge the market’s momentum. In 1978, W. Wilder found that there was no sufficient concept to determine the market’s exact bandwidth over a given period of time. Up to that point, traders had used the simple trading range. The simple trading range uses the market’s high and low to calculate the strength of a movement or the overall momentum.
Several indicators are based on the simple range concept. To judge momentum, you could simply add the simple range of periods with rising prices over a certain time and subtract the simple range of all periods with falling prices.
Depending on whether the resulting value is bigger or smaller than 0, and whether the value is increasing or decreasing, you can evaluate the current market direction and the strength of the movement. This way of analyzing the market has one big disadvantage: It does not account for gaps. Many gaps are a sign of strong movement, which makes them especially significant to trading range based evaluation.
Nonetheless, the simple range concept ignores them completely by only using the market’s high and low for its calculation.
To factor in gaps, W. Wilder invented the true range. In most cases, the true range uses the difference between high and low for its calculation as well. In case of a gap, however, the true range uses the difference from today’s high and yesterday’s close (in case of an upward gap) or the difference between today’s low and yesterday’s close (in case of a downward gap.
This way of calculating the market range factors in gaps and helps to create more complete picture of what is currently happening in the market.
How to use the true range for trading
There are a couple of different ways to use the true range for your trading.
1) As a general concept
First of all, you could use the true range to sharpen your understanding for the market. While candlesticks are easily recognizable in a chart, the truth is often hidden in the gaps between the candlesticks. Runaway gaps, breakaway gaps, and exhaustion gaps can provide you with a strong indication to what will happen next.
Knowing the true range can train you to pay detailed attention to what is happening between candlesticks. This focus on small, but important details can make you a far better trader.
2) As an indicator
There are a few indicators that use the true range as a basis for their calculation, most importantly the average true range.
The average true range calculates the average volatility of an asset over the last periods by subtracting the high of each period from the low and creating a smoothed moving average of the results. If there should be a gap in the market, the average true range will automatically use the previous periods close and the current period’s high / low (depending on the direction of the gap).
As a swing trader, you can use the average true range to evaluate the possible range of the current movement. Should you expect the market to rise and your broker offers you a touch option with a target price only twice as far away as the average true range, but an expiration time equal to three periods of your current chart, this would be a good chance for an investment.
In this case, the market should have three periods to move a distance he has only needed two periods for in the past. This event is likely to happen and gives you a good chance to win a touch option with a high payout.