41. How to Use the Average True Range (ATR) To Set Stops

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A lesson on how to include volatility in setting for traders of the stock, futures, and forex markets.

In our last lesson we looked at determining how much you are willing to risk on any one trade as the first step in developing a successful money management strategy. Now that we have established this, in today's lesson we are going to look at some of the different ways that you can then set your stop, which fit within this initial criteria.

As we learned in last lesson, risking more than 2% of total trading capital on any one trade is a major reason for the high failure rate of most traders. Does this mean that when setting a stop we should simply figure out how many points away from our entry represents 2% of our account balance and set the stop there? Well, traders could obviously do this and to be honest it would probably be a lot better than most of the other money management strategies I have seen, but there better ways.

Although many traders will look at other things in conjunction, having an idea of the historical volatility of the instrument you are trading is always a good idea when thinking about your stop loss level. If for instance you are trading a $100 stock which moves $5 vs. a $100 stock that moves $1 a day on average, then this is going to tell you something about where you should place your stop. As it is probably already clear here, all else being equal, if you put a stop $5 away on both stocks, you are going to be much more likely to be stopped out on the stock which moves on average $5 a day than you are with the stock that moves on average $1 a day.

While I have seen successful traders who get to know a list of the things they are trading well enough to have a good idea of what their average daily ranges are, many traders will instead use an indicator which was designed to give an overview of this, which is known as the Average True Range (ATR)

Developed by J. Welles Wilder the ATR is designed to give traders a feel for what the historical volatility is for an instrument, or very simply how much it moves. Financial instruments that exhibit high volatility move a lot, and traders can there fore make or lose a lot of money in a short period of time. Conversely, financial instruments with low volatility move a relatively small amount so it takes longer to make or lose money in them all else being equal.

As with many of the other indicators we have studied in previous lessons, Wilder uses a moving average to smooth out the True Range numbers. When plotted on a graph it looks as follows:

What you are basically seeing here is a representation of the daily movement of the EUR/USD. As you can see when the candles are longer (which represents large trading ranges and volatility) the ATR moves up and when the candles are smaller (representing smaller trading ranges and volatility) it moves down.

So with this in mind, the most basic way that traders use the ATR in setting their stops is to place their stop a set number of ATR's away from their entry price so they have less of a chance of being knocked out of the market by "market noise".

That's our lesson for today. In tomorrow's lesson we are going to look at how you can use volatility based stops in conjunction with another method traders use for setting stops based on technical levels so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn together and good luck with your trading!