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Determining optimal stop-loss placement is one of the great challenges facing active traders. Fortunately, the Average True Range (ATR) indicator can take much of the guesswork out of setting stops. 

In this article, we will break down how to leverage the ATR to size stop losses based on volatility systematically. Read on to understand the hidden features of the ATR for stop-loss optimization. 

 

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Overview of Average True Range (ATR) Indicator

The Average True Range indicator measures the degree of price volatility in a market over a specific period. It is based on the concept of True Range.

The True Range for any given period is simply the greatest of the following:

  • The current high less the current low
  • The absolute value of the recent high is less than the previous close
  • The absolute value of the current low is less than the previous close

The indicator takes an exponential moving average (EMA) of the True Range values for a given lookback period. The default setting is a 14-period ATR, but traders can adjust the lookback period to suit their needs.

The ATR provides an objective and standardized volatility measurement by smoothing out volatility and filtering out market noise. It can be applied across any market or time frame. The higher the ATR value, the greater the volatility is.

 

Using ATR to Set Stop Losses

 

Vector illustration of a candlestick chart featuring support and resistance levels


 

One of the most valuable applications of the ATR indicator is using it to set stop loss levels. Preventing losses is essential to risk management as it limits losses in a trade. Placing stops outside key support and resistance levels helps avoid a premature exit from good trades.

The ATR solves the problem of where to place stops by providing a volatility-based reference. Stops can be placed at multiples of the ATR to ensure they are an appropriate distance from current price action based on how volatile the market is.

A general guideline is to set stops at 2-3 times the ATR value above or below the entry price when going long or short, respectively. For example, if the 14-period ATR on the EUR/USD daily chart is 50 price interest points (PIPS), stops could be placed 100-150 pips away from entry.

This approach puts you in line with the market's volatility. When volatility increases, stops widen to lock in more profit. When volatility declines, stops are automatically executed to avoid unnecessary whipsaws.

 

Benefits of ATR Stop Losses

Using the ATR indicator to set stops provides several advantages:

Removes guesswork: ATR provides an objective volatility gauge to base stops on rather than subjective judgment

Adaptive: Stops automatically adjust to changing volatility conditions

Improved risk management: Wide stops in volatile markets and tighter stops for quiet markets

Allows room for normal retracements: Stops avoid premature exit during pullbacks

Standardized approach: ATR methodology can be consistently applied to different markets

Easy incorporation into trading strategies: ATR can be coded into automated or algorithmic systems

The ATR is available on most trading platforms and can easily be incorporated into manual trading approaches. While not a perfect solution, it does provide a statistically valid way to optimize stop placement.

Check this informative article: ATR Versus Alternative Volatility Indicators

 

Example of ATR Stop Losses

Let's go through a detailed example of how we can use the ATR indicator to set a stop loss on a trade:

  1. We are looking to go long EUR/USD as it is coming up to a critical resistance level at 1.1300, which aligns with the daily high.
  2. EUR/USD breaks above 1.1300, and we enter a long position at 1.1300.
  3. Before placing our stop loss, we check the current value of the 14-period ATR on the daily EUR/USD chart.
  4. The ATR reading is 30 pips.
  5. As a general rule of thumb, we use 2x or 3x the ATR value for stop placement. Let's go with 2x in this case.
  6. We take the ATR value of 30 pips x 2 = 60 pips for our stop distance.
  7. With our entry at 1.1300, we subtract the 60 pip stop distance to reach a stop loss level of 1.1240 (1.1300 - 0.0060).
  8. We placed our 60-pip stop-loss order at 1.1240 shortly after entering the trade.
  9. This ensures our stop loss adheres to the prevailing volatility conditions in the market as measured objectively by the ATR indicator.

Now that our stop is placed, we can sit back and let the market move. Our stop will automatically adjust up or down based on changes in volatility.

If volatility increased and the ATR rose to 40 pips, we could widen our stop to 80 pips from entry (2 x 40 pip ATR reading). This gives the trade more room to fluctuate in a volatile environment.

This article may pique your interest: Using Paper Trading To Test Indicators And Automated Systems

 

Points to Consider and Bonus Advice

 

Focus on a financial chart indicating market growth alongside a calculator and pen


 

While useful, the ATR has some important caveats that traders should consider. First, the ATR should be used alongside other forms of technical analysis for confirmation. 

Price action, chart patterns, and additional indicators should align with ATR-based stop levels. Using the ATR alone to set stops may lead to premature exit points or improper positioning.

Second, the standard 14-period lookback window may only be ideal for some markets and timeframes. Lengthening the lookback to 20 or 30 periods can reduce noise and whipsaws for higher timeframe trading. 

Shortening the lookback provides more responsiveness for short-term trading. Experimentation can help optimize the indicator's sensitivity.

Third, stop levels require additional adjustment based on evolving market conditions. In intense trending environments, widening stop distances from the ATR value allows the trend to extend. During range-bound choppy markets, narrowing stops closer to current price action prevents premature shakeouts.

Fourth, traders should manually adjust stops at key support and resistance levels rather than relying solely on a static ATR multiple. Rounding the ATR value up or down also helps optimize stop placement based on price increments and notable levels.

Fifth, considering trailing stops at a smaller ATR multiple allows traders to lock in open profits once a move has advanced. This balance gives the trend room to run while taking risks off the table.

Finally, backtesting across different markets and timeframes validates that ATR-based stops are reasonably accurate. No stop system is perfect, but the ATR accounts for evolving volatility. With proper optimization, traders can wield the ATR effectively within their overall trade management systems.

You might also like to read: 3 Most Effective Indicators for Crypto Trading

 

The bottom line

Though not foolproof, the data-driven ATR technique significantly improves subjective stop placement. Traders using the ATR to stop losses can benefit from better risk management without sacrificing profit potential.

When consistently applied, stops based on the ATR indicator offer smoother equity curves by avoiding premature stop-outs in quiet markets and excessive risk-taking in volatile markets. 

Next time you struggle with where to place stops, look at the ATR indicator. It could be the missing piece that takes your trading to the next level.

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.” 

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