Jan 17, 2024 11 min read

How to Calculate Stop Loss Using an ATR Indicator

ATR Stop Loss | AfterPullback

If you are to ask yourself, is there anything constant in the financial markets?

The answer can be, "Yes, Only Change is constant".

Markets keep on changing, and prices keep on going up and down. Still, the traders who can measure these “changes," these "price fluctuations," & this market volatility and act accordingly are the ones who are likely to make some profitable trades.

Therefore, understanding market volatility becomes crucial for making informed decisions &

how do you measure this volatility?

Through Volatility Indicators.

These indicators provide insights into the intensity of price movements, helping traders gauge potential risks and rewards.

There are many Volatility Indicators in the market;

Bollinger Bands, Volatility Index (VIX), Relative Volatility Index (RVI), Chaikin's Volatility (CHV) & Volatility Stops, etc are just to name a few; all are measuring the price movement and market volatility through different mechanisms.

But one of the most popular volatility Indicator among traders is

Average True Range ( ATR)

Traders often use the ATR to set stop-loss levels, determine position sizes, and identify potential breakout points. Its adaptability makes it valuable across various trading strategies, from day trading to long-term investing.

In the Sections below, we'll explore the mechanics of the Average True Range, how it is calculated, its applications in different market scenarios, and practical tips on incorporating it into your trading toolkit.

So let's go ahead and try to understand how it works;

What Is the Average True Range (ATR)?

The ATR is an indicator that calculates the average true range of price movements over a specified period; by factoring in both intraday price swings and gaps between sessions, the ATR delivers a more accurate reflection of a security's true volatility, going beyond the limitations of traditional measures.

The Indicator was created by a technical analyst named J. Welles Wilder, Who designed it to help us understand how much the prices in the market are swinging around. Unlike other tools that try to predict where prices might go, ATR doesn't predict the direction; instead, it tells us how much prices are moving.

How to Set Stop Loss with ATR

Setting a stop loss is a crucial aspect of risk management in trading, and using the Average True Range (ATR) can be an effective method. Here's a step-by-step guide to help you set a stop loss using ATR:

· Step 1: Understand the ATR Calculation

· Step 2: Determine the ATR Value

· Step 3: Assess the Current Market Conditions

· Step 4: Decide on ATR Multiplier

· Step 5: Calculate & Apply the ATR-Based Stop Loss

· Step 6: Set Multiple Take Profit (TP) Targets Using ATR

· Step 7: Regularly Review and Adjust

Let's understand each step in detail;

Step 1: Understand the ATR Calculation

As you might have understood by now, the ATR, or Average True Range, quantifies the average range between the high and low prices over a specified number of periods.

For instance, a common setting for ATR is 14 days, although traders can adjust this parameter based on their preferences and trading strategies.

To calculate the ATR, the Indicator considers the true range of price movements during the chosen periods. The true range is essentially the greatest of the following three values:

High minus Low: The absolute difference between the highest and lowest prices within a given period.

Absolute Value of (High minus Previous Close): This accounts for any potential gap between the previous day's closing price and the current day's high.

Absolute Value of (Low minus Previous Close): Similar to the previous point, this considers the potential gap between the last day's closing price and the current day's low.

By factoring in these components, the ATR provides a more comprehensive assessment of market volatility than a simple price range calculation. It accommodates price gaps between trading sessions, more accurately reflecting a security's true volatility.

Step 2: Determine the ATR Value

Calculate the ATR for the chosen period. This information is found on most trading platforms or financial websites that provide technical analysis tools. The ATR value represents the average volatility over the specified period.

A rising ATR may signify escalating volatility, potentially indicating the onset of a trending market or heightened uncertainty. Conversely, a declining ATR may suggest decreasing volatility, signaling a period of consolidation or reduced market activity.

Traders can adjust the ATR period to align with their preferred timeframes, whether short-term for day trading or longer-term for swing trading or investing.

Step 3: Assess the Current Market Conditions

Have a look at the market conditions before applying the Average True Range (ATR)

Why?

This careful evaluation allows traders to tailor their approach, adjusting risk parameters to match the level of volatility characterizing the market at a given moment.

While analyzing the market conditions, you have to;

Determine Market Volatility:

Begin by analyzing the overall volatility of the market. A quick glance at recent price movements can provide insights into whether the market is experiencing heightened or subdued volatility. We know that initially, it's difficult to gauge the market at a glance, but higher crests and troughs in the charts can be a good starting point to understand that the market is volatile and vice versa.

Consider External Factors:

Read the News! They say it.

It would help to consider any external factors that might influence market conditions. News events, economic releases, geopolitical developments, or unexpected market shocks can significantly impact volatility. Staying informed about these factors can help you anticipate potential changes in market dynamics.

Adapt to Market Phases:

Another crucial aspect when using ATR,

It would help to recognize that markets go through different phases, including trending and ranging. During trending phases, the ATR may reflect larger price movements, while during ranging or consolidating phases, the ATR might be comparatively smaller.

So you have to Adjust your risk management strategy accordingly,

For example, in a trending market, you may place stop-loss orders below (in an uptrend) or above (in a downtrend) key support or resistance levels to align with the current market phase. You may also be using trailing stops in an uptrend, allowing you to capture profits while staying in the trade as long as the trend persists.

Similarly, in Range-Bound Markets, characterized by sideways price movements between support and resistance levels, you may reduce the Position Sizes due to lower volatility. As the prices tend to revert to the average in range-bound markets, you may also place the stop losses just outside the range.

Factor in Timeframes:

You also have to Consider the timeframe of your trades.

Short-term traders might respond more acutely to intraday volatility, while longer-term investors may focus on broader trends. Adjusting the ATR period to match your trading timeframe helps align risk management with your specific goals and preferences.

Step 4: Decide on ATR Multiplier

Choose an ATR multiplier based on your risk tolerance and trading strategy. Common values range from 1 to 3. A higher multiplier will result in a wider stop loss, while a lower multiplier will lead to a narrower stop loss.

Which Multiplier to Choose depends on two personal preferences,

Number 1 is your risk tolerance level.

Consider using a higher ATR multiplier (e.g., 2 or 3) if you are comfortable with larger price swings and willing to endure more significant fluctuations before triggering a stop loss.

This approach suits traders who tolerate higher volatility and focus more on long-term trends.

On the other hand, Opt for a lower ATR multiplier (e.g., 1) if you have a lower risk tolerance and prefer tighter risk control. This results in a narrower stop loss, minimizing exposure to large price movements.

This strategy is appropriate for traders who prioritize capital preservation and are more risk-averse.

Number 2, It also depends on your Trading Strategy:

A higher ATR multiplier may be beneficial if you are following a Trend-Following Strategy or operating in a trending market where prices are making substantial moves. This allows your trades more room to breathe, aligning with the trend's momentum. For Example, You may use an ATR multiplier of 2 or 3 for these markets.

Similarly, if you are trading on a Range-Bound or Mean-Reverting Strategy

In markets with lower volatility, a lower ATR multiplier may be suitable. This provides tighter risk control for trades within a confined price range.

Step 5: Calculate the ATR-Based Stop Loss & Apply the Stop Loss.

Calculating the Stop Loss:

Once you have identified which multiplier to choose and which market to operate in, the next step is the calculation of stop loss to apply. This is a fairly simple process.

High-Risk Tolerance and Trending Market: Let's say you have a higher risk tolerance, and you're trading in a market characterized by a strong trend, resulting in larger price swings. In this scenario, you might opt for a higher ATR multiplier, perhaps 3. This higher multiplier accommodates the increased volatility, allowing for more significant price fluctuations before triggering a stop loss.

ATR for the chosen period: $2 (as an example)

ATR Multiplier: 3

The ATR-based stop loss calculation would be:

ATR-Based Stop Loss=ATR Value × ATR Multiplier

ATR-Based Stop Loss = $2 x 3 = $6

This implies that your stop loss would be $6 below the current price for a long position or above for a short one. The wider stop loss aligns with the higher market volatility associated with trending conditions.

Lower Risk Tolerance and Range-Bound Market: Now, consider a scenario where you have a lower risk tolerance, and the market is exhibiting a range-bound behavior with smaller price swings. You might choose a lower ATR multiplier, such as 1, to implement a more conservative risk management approach.

ATR for the chosen period: $1 (as an example)

ATR Multiplier: 1

The ATR-based stop loss calculation would be:

ATR-Based Stop Loss=ATR Value× ATR Multiplier

ATR-Based Stop Loss = $1 x 1 = $1

Here, your stop loss would be $1 below the current price for a long position or above for a short position. The narrower stop loss aligns with the lower market volatility expected in a range-bound environment.

Applying the Stop Loss:

Once Calculated, you implement your trade's calculated ATR-based stop loss level. For a long position, subtract the ATR-based Value from the entry price, and for a short position, add it. This establishes a stop loss that dynamically adjusts to market volatility.

For example, Continuing the above example of a trending market, If you are in a long position (buying the stock), subtract the ATR-based Value from the entry price to establish the stop loss level.

For example, if your entry price is $50, the adjusted stop loss for a long position would be $50 - $6= $44.

If you are in a short position (selling the stock), add the ATR-based Value to the entry price to determine the stop loss level.

Assuming the entry price is $48, the adjusted stop loss for a short position would be $48 + $6 = $54

Step 6: Set Multiple Take Profit (TP) Targets Using ATR

While your stop loss aims to limit potential losses, take profit targets lock in your desired gains.

These are predetermined price levels where you would close your trade and take your profits, locking in your gains. Aiming for multiple TP levels allows you to secure profits at different stages of a potentially positive trend.

Here's how to leverage ATR for multiple TP levels:

Initial Take Profit (2x ATR): Aim for a profit of 2 times your ATR as a base target. This aligns with your risk-reward ratio of 1:2.
Trailing Take Profit (3x ATR): For a portion of your position, consider a trailing stop-loss set at 3x ATR. This allows you to capture further gains if the trend continues beyond your initial target.
Advanced Take Profit (4x ATR): For a smaller portion (optional), utilize a stop-loss based on 4x ATR as a more aggressive profit goal. Remember, higher rewards also come with increased risk.

The Crux is that you dont sell everything when your risk reward ratio is achieved but you take proportionate profits at regular intervals.

Step 7: Regularly Review and Adjust

Market conditions can change, so in some cases, you may need to to regularly review and adjust your stop loss based on the updated ATR values. Periodically reassess the market's volatility and adjust your stop loss to protect your capital.

Conclusion

Setting a stop loss with ATR is a proactive risk management approach that aligns your trading strategy with market volatility. Incorporating this method into your trading routine and staying vigilant about changing market conditions can enhance your ability to preserve capital and manage risk effectively. Remember, risk management is a key component of successful trading.

So,

Trade Smarter!

Frequently Asked Questions (FAQs)

Q1: How do you use an ATR Indicator for Scalping?

A1: For scalping, use the ATR indicator to determine market volatility. Set tight stop-loss orders based on ATR values, and define realistic profit targets based on current ATR Value, helping you adapt to short-term price fluctuations.

Q2: What is the difference between the average true range and daily range?

A2: The Average True range (ATR) measures overall market volatility, considering gaps and limit moves. In contrast, the average daily range (ADR) focuses solely on a security's price range within a single trading day.

Q3: Is a High ATR good?

A3: A high ATR indicates increased volatility, which may present opportunities for traders seeking larger price movements. However, it also implies higher risk, so careful risk management is crucial.

Q4: How do you use ATR for options trading?

A4: One of the ways to use ATR for options trading is to estimate more accurately the range of the asset's price action movement, and take advantage of it to enter relevant option position with realistic targets with higher probabilities.

Q5: What is a good ATR Value?

A5: There's no universal "good" ATR value; it varies based on the asset and trading strategy. Traders often compare the ATR to the stock's current price to assess volatility relative to the stock's Value.

Q6: What is the difference between ATR and standard deviation?

A6: ATR measures market volatility, considering price gaps, while standard deviation assesses the dispersion of prices from the mean. ATR focuses more on actual price movements, whereas standard deviation is a statistical measure of price variability.