'ATR is highly correlated to volatility & tends to be much more normally distributed'

[Dogpile 10]

http://www.activetradermag.com/strategy.htm

 

This is interesting article discussing how ATR as a proxy for volatility can be useful.

 

Why is this meaningful?

 

Well, normal distributions have well-defined statistical qualities. This topic feels relevant to jperls recent series of excellent topics.

 

I will present one idea using this information with hope of stimulating some useful conversation on this topic with regard to intraday futures trade set-ups. I am still developing this idea but wanted to present the article first to get others to think about the implications of this concept in concert with their own trading methods.

[Dogpile 10]

You see one of your trade set-ups and you are considering entering a futures position.

 

How do you know if the ‘location’ of this trade allows plenty of room for profit potential?

 

This is an idea for trying to think about location (for entering with good location and therefore implying good profit potential) that uses ATR and VWAP. The goal is simply to create some discussion around this topic. This is certainly not intended to be a lesson.

 

I like to think of VWAP as a starting point for price action. In my opinion, price action relative to VWAP is some of the most consistently important price action of the trading day.

 

What are some of the basic things the market can do if starting near VWAP:

 

1. The market can cling to the VWAP level – forming a ‘balance’ – a coil.

2. The market can push away from VWAP with momentum and sustained trending action.

3. The market can attempt to go one direction away from VWAP with momentum and strong conviction -- but then reverse (a classic trap) and shoot the other direction.

4. Finally, the market may just not care about VWAP and oscillate with no real respect for this level.

 

I want to focus on the cases where price is in the vicinity of VWAP and you get some kind of an entry signal that you are considering taking as a discretionary trader (entry signals are not really the thrust of this thread).

 

In my view, any well-defined pattern around VWAP or a simple ‘momentum-based push’ away from VWAP may be a good time to take an entry signal. You can never know with certainty which of the above cases will occur but if you can determine a reward point that the market may trade to, you may find it to be worthwhile to get a trade on for the mere potential reward of having the right read.

 

The first attached chart is a situation where I believe the market is ‘in balance’ – price is consolidating near the VWAP price and meandering without conviction. Quantitatively, you could call it a ‘Low ADX’ consolidation-- pattern-wise, you could say the it is congesting because you are able to draw ‘converging trendlines’ (ie, you can draw a triangle type of formation/consolidation).

 

Now let’s think backwards, if you think you know how far the market could carry if it does start to move directionally (break the ‘balance’), then you can probably figure out a location that is ok to enter as it leaves you enough room to take a position and make a nice profit. Then you can take trades whenever your personally-defined trades set-up in this ‘execution zone’…

 

Chart 2 shows the same market coil as Chart 1 but I have added the ‘target’ levels. This is where I am estimating price as eventually moving to over the course of the day. This is simply an ATR function off of VWAP. If VWAP is ‘fair value’ – and the market is ‘in balance (low ADX triangle) – then estimating the future movement off of the existing ‘balancing’ is pretty flawed. A market that is ‘trending’ and a market ‘in balance’ are opposites. Determining a trend off of a period of balance is going to be difficult to make work. But I see this type of thing on the vast majority of trading days – some kind of balancing followed by price auctioning to a new level.

 

A Rashke principle is that of a markets tendency to ‘trend’ in the ‘afternoon session’ (after lunch) – when volume picks up as institutions tend to trade more heavily in the afternoon. Why don’t we use this trending action of the previous afternoon as a guideline for todays trending action? This makes more sense then trying to use the morning congestion because of the difference in afternoon and morning trading. And let’s use Average True Range to estimate such.

 

Chart 3 shows how the market moved after breaking away from its coil/balance on Friday

 

Chart 4 shows how this level has worked over last 6 days.

 

The formula I used was simply to add and subtract 5 ATR’s from VWAP with ATR calculated using the previous days final 3 hours of trading (180 2-minute bars average ATR). I used 5 because it is a Fibonnacci number and I always start with those. This is a 2-minute chart and 5 ATR's off a 2-minute chart seems to be hit a lot. In more extreme days -- 8 ATR's (next fib number up) might be inserted. This is just a guideline for determining potential reward based on previous days ATR. This is not supposed to be any holy grail type of discovery -- its just a way to visualize where price could trade to when you see one of your set-ups -- a time when it is often tough to see the forest for the trees.

[Dogpile 10]

Chart 4 shows how this level has worked over last 6 days.