Getting stopped out of positions is a common occurrence for all traders. There is a sense of relief involved when a positions gets worse after your stop is triggered, but it can be incredibly frustrating to get whipsawed out of a position only to watch it rocket higher.
Accounting for volatility in your stop placements helps reduce the chance of a whipsaw trade. Fixed distance stop losses don’t bring the same advantage.
Using Average True Range (ATR) To Set Initial Stops
Average True Range (ATR) represents the average range that a market moves over a given time period. Using a multiple of ATR allows a trader to give highly volatile positions enough room to run, while at the same time making sure that low volatility positions are held tightly in check.
I typically set my initial stop 3ATRs below a new position. If that’s new lingo to you, it means that I take the ATR and multiply it by 3. If you bought LNKD at 178.66 and its ATR was 6.22, then you would set your initial stop 18.66 below you entry point, which would be 160.00 if there was no slippage. Based on your own personal risk preferences, you can use any multiple of ATR in order to take into account that market’s historical volatility.
What Is Average True Range (ATR)?
The concept of Average True Range (ATR) was originally introduced by J. Welles Wilder in his 1978 book New Concepts in Technical Trading Systems. Wilder was looking for a way to describe the historic volatility he was encountering in commodities markets.
Wilder took the True Range indicator and smoothed it out using an exponential moving average. The most common time frame for ATR is 14 days.
True Range is calculated using the following formula:
true range = max[(high-low), abs(high-prevclose), abs(low-closeprev)]
By adding the second two components of this formula, Wilder was able to account for gap up and gap down situations that True Range struggled with. True Range only measures the change within a bar and not the change between two bars.
My Evolution To Using Average True Range (ATR)
When I began my trading career over a decade ago, I didn’t think I needed to bother with setting an initial stop loss. I was only going to be buying stocks that went up, so I had no reason to worry about downside risk. That was for suckers who couldn’t identify growth stocks.
Experience humbled me. I was likely to be wrong on as much as 50% of my trades. As I began to come to terms with the fact that I was not a perfect stock picker, I started to see the need to set a stop-loss order when I established a position.
My reading informed me that Livermore and Loeb recommended no more than a 10% stop. O’Neil recommended a 7-8% stop.
Since I still viewed myself as quite gifted, I figured that a 7% stop would work for me because I was only dealing with the very best stocks, and it was very uncommon for them to lose 7% from a breakout…..or so I thought.
As I continued to lose money, a very intelligent trader pointed out to me that I was not even considering the volatility of each of the stocks I was buying. Some of the stocks on my watch list would move 2-3% up or down everyday, but some of them rarely moved more than 0.5%. This explained why it felt like some of my positions had too much room and others felt way too tight. Experience taught me that looking at volatility just makes sense.
Example ATR Comparison
The chart of LNKD above showed a stock with a 6.22 ATR. As a point of comparison, here is a chart of MSFT, which has an ATR of 0.504.
Even a novice trader can see that there is a huge difference in volatility between these two stocks. Since LNKD moves with much more dollar volatility than MSFT, it will need more room to work with if you establish a position. Conversely, MSFT doesn’t need much room at all because of its low volatility history.
Using ATR For Trailing Stops
ATR extends beyond setting the initial stop loss. The indicator also works for setting trailing stops as a position becomes more profitable, such as in the RSI Trend strategy. A simple application of this is to keep the stop updated to be a mutliple of the market’s ATR below the high of the position.
Using ATR as a trailing stop can help to protect your profits, while at the same time give your position enough room to move.