Using the Average True Range indicator (ATR) is a smart way to determine where your stop loss should be placed.
While there are other ways including using support resistance levels, candlestick swing highs or low, and even trend lines, ATR stops use volatility.
ATR Stop Method – Why Use It
Price volatility can often make trading difficult. As price whips back and forth, it is easy for a stop to be taken out during erratic swings when market conditions are tough.
We’ve all had instances where our stop gets ticked out, and then on to the profit targets we had. It is hard to watch a solid risk reward trade broken down because you decide to keep a tight stop loss which is usually done to increase position sizing.
By using the ATR, we take advantage of the range of price over a set period of time and then is averaged out.
You learn more about ATR and the calculation by reading: 2 Ways To Use Average True Range For Better Trading
Using An ATR Multiple
We can use multiples of the ATR reading (2x, 3x, 4x)and this is where you decide your risk tolerance and the market you are trading.
If the market I am trading has large swings, I may choose to use a larger multiple from 3-6. A quiet market, I may use 1.5-2.5 as the multiplier. There will never be a perfect number.
This is a 14 period ATR setting and in this case, the current ATR value is $ 8.77 (ETHUSD). This means that the average range of price movement up/down, is $8.77.
Using a multiple of the ATR indicator is simple:
- 1X = 8.77 x 1 = 8.77
- 2X = 8.77 x 2 = 17.54
- 3X = 8.77 x 3 = 26.31
All this means is that from a point you decide, you would add or subtract any of those amounts from the price.
One thing to keep in mind, the correct ATR reading will not be known until the closing price of the candlestick closes. Depending on how you trade, you may have to use the previous reading.
ATR Stop Loss Strategy
Imagine your trading strategy has you entering momentum candlesticks at close. Your entry price is $402.70 and you have chosen to use 2x ATR to place your stop loss.
You would calculate the stop location: $402.70 – (8.77 x 2) = 402.70 – 17.54 = ATR based stop loss location at $385.16.
Staying with our current example:
If price moves 2 x the average true range to the downside, your trading strategy would determine that is a big move and you would exit this trade.
Let’s look at a different example.
This is a day trading stock chart and in this strategy, imagine you play pullbacks after a breakout.
- Price breakout of highs and you set a limit order to go long at $74.28
- Since you are using a limit order, you need to use the last printed candlesticks ATR reading (red arrow)
- You set the stop loss at 1 x ATR = .19 or 74.28-.19 = $74.09
Your trade takes some heat but you manage to ride a momentum move upwards.
High, Low, OR Close?
One question you need to answer is where you will calculate the stop loss location from.
- Will you use the high price of a bar minus the ATR?
- Will you calculate from the closing price?
- How about using the low price?
Is there a difference? There certainly is depending on the candlestick you enter your trade on.
In this stock chart, your day trading strategy is a pullback after a breakout and then you buy stop the high of the candle that pulled into your zone.
You set the stop 1 x ATR from the high of the setup candlestick and you enter the trade. Notice that large candle that almost pops you from the trade before roaring into profits.
From the low or the closing price of the setup candle, you would be far enough away to keep you from biting your nails.
But now we have to deal with another issue.
Your stop loss will also depend on your risk parameters for each trade and your overall account.
Going back to the last chart, let’s see what risk we are really looking at.
Where you calculate your stop from will depend on how you look at range.
- Are you using your entry price and any ATR multiple from that price invalidates your trade?
- If long, do you consider the takeout of lows an indication of a failed trade?
- If your entry is somewhere in the middle of the candle, do you consider the high part of the range?
Using that chart with 1 x ATR:
- The first stop is from the high as you use a breakout for an entry and adverse price action from highs invalidates the trade
- The second stop you still use the breakout but you want the trade to have a little more room to breathe. You pay higher for the insurance.
It’s personal preference and limited by your trading account size.
ATR Trailing Stop Loss
Letting profits run while respecting the volatility of the market is a popular method of trading. The ATR can keep your stop further from volatile price action and close during smooth price action be used as a trailing stop loss.
Why is that important?
During smooth price action, any large move against your position points to a change in the market. You’d not want to be holding when momentum shifts against you.
Trailing your stop loss an average range distance from current price action is an objective means to manage your trade.
Here are three ATR lines set at high, low, close and 2 X ATR.
The entry candle, as an example, is the black arrow. Keep in mind that even though the third candle from the left touches the line, you would not exit the trade. That price for the ATR is not set until the candle closes.
You can see the various locations you’d be taken out of the trade. The red line, the low, may or may not have been filled at that location.If not, you would have been taken out 1.5% higher on this chart of crude oil futures.
Whichever you use, the key is to be consistent in your approach. You also never move the stop further away from your position.
The ATR stop loss placement is a viable approach to trading.