Setting Stops With Average True Range

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You may have read that many traders use the average true range for setting their stop losses. The reason is that the average true range is a fantastic measure of volatility and market noise.

Very simply, the average true range (ATR) determines a security’s volatility over a given period. That is, the tendency of a security to move, in either direction.

More specifically, the average true range is the (moving) average of the true range for a given period. The true range is the greatest of the following:

  • 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

The average true range is then calculated by taking an average of the true ranges over a set number of previous periods. Care should be taken to use sufficient periods in the averaging process in order to obtain a suitable sample size, i.e. an average true range using only 3 periods would not provide a large enough sample to give you an accurate indication of the true range of the security’s price movement. A more useful period to use for the average true range would be 14.

The value returned by the average true range is simply an indication as to how much a stock has moved either up or down on average over the defined period. High values indicate that prices are changing a large amount during the day. Low values indicate that prices are staying relatively constant. Note that both trending and level prices can have high or low volatility.

So, how can we use the average true range in calculating our stop loss? All you do is you subtract a multiple of the average true range from the entry price. I might take two times the average true range and subtract it from my entry price. For example, if we had a one dollar stock and its average true range value was five cents, I would simply take a multiple of the average true range, which I said we’ll use two in this example, and we’d subtract it from our entry price. So, two times our average true range is ten cents, subtracted from our entry price gives us a stop loss value of 90 cents.

Now, by adhering to this pre-defined point at which I sell, I know that if the share price doesn’t move in my favored direction, and actually moves against me, I already know the point at which I’m going to sell. My emotions are removed from the equation, and I just simply follow what my stop loss says. This is how most successful traders limit their losses. They know when they’re going to sell and they have this pre-defined before they even begin trading. Although their methods of calculating the average true range and the stop loss may be different the one common element here is that they have a stop loss in place.

Here’s a little extra finesse point that you might look at including in your trading plan. I sometimes introduce a time stop depending on the type of system I’m trading. This type of stop simply takes you out of a position after a fixed amount of time if I haven’t made enough profit.

To successfully implement this type of stop, you’re going to have to work out the average true range and do some sort of back testing, to find out if it’s appropriate for the particular instrument you’re trading. I just thought I’d throw that in there to make sure you have all your bases covered.

When you first begin calculating your average true range and outlining your stop losses, just keep in mind what Tom Baldwin, the successful trader said. He said the best traders have no ego. You have to swallow your pride and get out of your losses. He’s simply referring to having a stop loss set, and more importantly, having the discipline to stick to it.

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