ATR (Average True Range) is a really simple indicator to measure the volatility of a certain market. Every market has different volatility and the volatility of each market changes over time.
When we are testing a strategy's best take profit distance for a market over a certain period of time, let's say a year, we don't usually consider that the volatility of a market can change from 70 pips per day to 40 pips in that time, that change is huge (40%).
So picking a fixed ATR for a pair like 7 pips, wouldn't give us the best results, we would have to adapt it constantly to the volatility to make it work better.
Let's elaborate a bit more:
If EURUSD ATR for the day (20 days period ATR) is 45 pips and it behaves well with a 5 pips TP in a forward test, then GBPUSD with 90 pips ATR could go for around 10 pips give or take.
Thinking in terms of ATR is very convenient in this case. If we have an ATR based take profit, we wouldn't need to test TP consistently over time (we will need to, but not that much). We would only need to use a % of the ATR as TP.
If the volatility of a market changes over time, so will the take profit. If volatility rises we can take advantage of it, if it diminishes too since our take profit is smaller and price might reverse faster.
How would it look in my mind?
ATR based take profit:
Daily ATR (periods): #
TP % of ATR: #
And that's it. Simple.
Note that this idea can apply not only to TP but also to every part of the position management, like stop-loss and trailing stops but this would be a start.
This suggestion was migrated from the old forum and originally posted by Diego