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How to Use Average True Range as a Twist for Stops

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January 1, 2012

A common statement I get from new traders is that they feel good about their entries, but just don't know when to get out. Unfortunately, a statement like this typically has accompanied a large loss. This inevitably leads to a conversation about the No. 1 rule of the jungle—control thy risk. Easier said than done, right? Small losses can be made up, but large, uncontrolled losses really hurt. One way that might help control your losses is to use the Average True Range (ATR) indicator in your charts to assist with calculating where to put your stop losses.

Before we get down to the nitty-gritty of how some have used used ATR, let's discuss some basics. At its heart, ATR is a volatility indicator, and is pretty straightforward. For a daily chart, the “True Range” of a stock is the higher of 1) the high minus the low of the day, 2) today's high minus yesterday's close, or 3) yesterday's close minus today's low.

In essence, we're trying to figure out how much movement might occur from one period to the next. Stocks may close on average one to two points a day, for example, but the range of a day/week/month typically exceeds that. Since there can be a fair amount of volatility with true range, the indicator looks at the average of the “true range” to smooth things out.

Calculate Your Stop

So, how do you apply ATR? The table is an example of how you can use the concept of Average True Range for several trading strategies.

FIGURE 1: For illustrative purposes only. 

In the table, when I use the word trend I'm referring to riding the up and down swings of a stocks cycle as long as the so-called “trend” is intact. Swing trading would be exclusively trading the up or down swings within the stock's cycle.

Let's go through a trend trading example. In Figure 2 you'll see a price chart of the XYZ with an ATR (14) study applied just below the price graph. 

Average True Range

FIGURE 2:

How you apply Average True Range as a stop depends on how long you plan to spend in your trade, which is usually marked by what type of trader you are—i.e. long, medium, or short-term. For illustrative purposes only. 

The current ATR (14) is $32.1, meaning that over the last 14 days this stock fluctuated, on average, $32.1 from one day to the next. As a result, the initial stop will be placed a minimum of $64.2 below the entry price for a trend trade, which is something you can do right from both the thinkorswim or Trade Architect trading platforms. 

Seriously, that's it. No complex formulas here. So, the next time you're feeling out in the cold with your exit strategy, maybe you'll find some warmth with this simple approach using Average True Range.

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