The Average True Range, and the stop loss it builds

Very simply, the Average True Range (ATR) measures a security's volatility over a given period: its tendency to move, in either direction. It is the moving average of the true range, and the true range of any bar is the greatest of:

• the difference between the current high and the current low
• the difference between the current high and the previous close
• the difference between the current low and the previous close

Average those true ranges over a set number of previous periods and you have the ATR. Take care to use enough periods to get a decent sample: an ATR built on only 3 periods is too small a sample to tell you anything reliable about how the security really moves. A more useful setting is 14 periods.

Reading the value

The number the ATR returns is simply how much the stock has moved, up or down, on average over the defined period. High values mean prices are travelling a long way each day; low values mean prices are staying relatively constant. Note that both trending and sideways markets can show high or low volatility: the ATR measures movement, not direction.

Turning ATR into a stop loss

So how do we use it? Subtract a multiple of the ATR from your entry price. I might take two times the ATR: on a one dollar stock with an ATR of five cents, two times the ATR is ten cents, and ten cents below the entry gives a stop loss at 90 cents.

By adhering to that pre-defined exit, I already know the point at which I sell if the share price moves against me. My emotions are removed from the equation; I simply follow what the stop loss says. This is how most successful traders limit their losses. Their methods of calculating the ATR and the stop may differ, but the common element is that the stop exists, and it exists before the trade is entered.

A finesse point: the time stop

Depending on the system I'm trading, I sometimes add a time stop: it takes you out of a position after a fixed amount of time if the trade hasn't made enough profit. To implement one properly you'll need to work with the ATR and do some back testing to confirm it suits the particular instrument you're trading. Not essential, but worth having in the plan so your bases are covered.

The Baldwin rule

When you first start calculating ATRs and placing stops, keep in mind what the trader Tom Baldwin said: the best traders have no ego. You have to swallow your pride and get out of your losses. He is talking about having a stop loss set, and more importantly, having the discipline to stick to it. How much you risk before that stop is hit is the other half of the story: that's covered in how much trading capital to risk per trade.