How to Use ATR (Average True Range) to Set Your Stop Loss
The Average True Range (ATR) is a popular technical indicator used by traders to measure market volatility. Unlike many other indicators, ATR does not provide signals for entry or exit points but helps traders understand how much an asset typically moves in a given period. This makes it an invaluable tool for setting stop loss orders that are more aligned with market conditions. In this article, we’ll explore how to use ATR to set a more effective stop loss.
Understanding the ATR Indicator
Developed by J. Welles Wilder Jr., the ATR calculates the average of true range values over a specified number of periods. The true range is the greatest of the following:
- The current high minus the current low
- The absolute value of the current high minus the previous close
- The absolute value of the current low minus the previous close
The most common setting for ATR is 14 periods, but traders can adjust this based on their strategy and the asset being traded.
Why Use ATR for Stop Loss?
Using ATR to set your stop loss allows you to account for the natural volatility of the asset, rather than placing arbitrary price levels. This helps avoid being stopped out prematurely due to normal price fluctuations, while still protecting your capital from significant adverse moves.
How to Calculate a Stop Loss Using ATR
Here’s a step-by-step method to use ATR for setting your stop loss:
- Determine the current ATR value for your asset using your trading platform’s indicator tools.
- Decide on a multiple of ATR that suits your risk tolerance. Common multiples range from 1x to 3x ATR. For example, a more conservative trader might use 2x ATR, while a more aggressive trader might use 1x ATR.
- For long positions, subtract the chosen multiple of ATR from your entry price to set your stop loss. For short positions, add the multiple of ATR to your entry price.
Example for a long position:
If you’re buying a stock at $100 and the ATR is $2, and you choose to set your stop at 2x ATR, your stop loss would be:
$100 - (2 x $2) = $96
Advantages of Using ATR for Stop Loss
- Adapts to volatility: Your stop loss will widen in volatile markets and tighten in calmer markets.
- Reduces premature exits: Helps you avoid being stopped out by normal price noise.
- Objective and consistent: Provides a data-driven approach to risk management.
Final Thoughts
Using the Average True Range (ATR) to set your stop loss is a powerful way to tailor your risk management to current market conditions. By incorporating ATR into your trading strategy, you can create stop loss levels that are more logical and less arbitrary, ultimately improving your chances of long-term success in the financial markets.
Remember, no stop loss strategy is foolproof, so always combine ATR with other risk management techniques and maintain a disciplined trading approach.