Every trading participant has been stopped out of a trade, only to watch in disbelief as the market reverses and surges in the direction that was originally predicted. This is actually quite common and can become enormously frustrating—leaving one with the feeling that the market really is against them.
The good news is that there’s a solution to help you place your stop-losses more strategically, enabling you to avoid untimely exits. That solution can be found in one very powerful tool known as the Average True Range (ATR) indicator. The ATR has been widely recognized for its ability to measure the volatility of markets, and when used correctly, it really can revolutionize the way you manage risk in your trades.
We’ll dive deep into how you can leverage the ATR indicator to place smarter stop-losses in this article. You will then be able to protect your trades better and allow breathing space for your strategies to work out as they should when you understand and apply this tool.
Knowing the Average True Range (ATR) Indicator
The Average True Range is a technical analysis indicator developed by J. Welles Wilder Jr. It’s designed to measure the volatility of the market by indicating how big an asset’s price can move, on average, over a given period. There is no indication of price direction that the ATR signals; it simply shows the degree of price movement, which is very important in risk management.
ATR’s Key Features
- Volatility Measurement: ATR helps a trader understand the extent of volatility in the market. An increased ATR reading indicates more volatile situations. Usually, lower ATR readings bring forth a calmer market.
- Time Frame Analysis: ATR can work in any time frame, from daily, hourly, to minute-by-minute price action. Your most common setting would be a 14-period ATR, which rolls out an average for the true range from the last 14 periods.
- No Directional Bias: While most indicators normally define buy or sell signals, ATR itself provides absolute price ranges, making it suitable for both trend-following and range-bound strategies.
Why Stop-Loss Placement Matters
One of the most important constituents of any trading strategy is a stop-loss order. It saves your capital from losses that can spring as surprises when the market works against your position. Nevertheless, a stop-loss at the wrong level may result in unnecessary exits and the loss of opportunities. This is where the ATR indicator comes in.
Common Mistakes in Placing a Stop-Loss
- Too Tight Stop-Loss: Placing the stop-loss too close to the entry price can get you stopped out too early because of normal market swings.
- Too Loose Stop-Loss: Setting this too far out can expose you to larger-than-necessary losses if the trade goes wrong.
Solution with ATR
The ATR indicator helps you set a stop-loss at an appropriate level, including the asset’s volatility to decrease the chances of being stopped out because of random noises in the market.
3 Steps How to Use the ATR Indicator for Stop-Loss Placement?
Step 1: Installing the ATR Indicator
First, you want to add the ATR indicator onto your trading chart. Most trading platforms already have this indicator by default. Alternatively, it can be downloaded on TradingView.
- Go to the Indicators tab on your platform.
- Find “ATR” and then click “Average True Range.”
This positions the ATR line at the bottom of your chart, and in many cases, it defaults to a period of 14. This creates an average for the true range over the last 14 periods, giving a balance that’s agreeable to most trading styles.
Step 2: Interpreting the ATR Value
The ATR reading that appears on the chart represents the average range by which the underlying security price changed over the period selected. For example, when trading oil, while viewing an ATR of 1.88, you may assume that the oil price is likely to either rise or fall by $1.88 over the period represented by those particular ATR settings.
Step 3: Applying the ATR to Your Stop-Loss
Literally, the common guideline is to place your stop-loss at 1.5 times the current value of the ATR. This multiplier gives enough room for expected volatility, but it also gives ample space for the trade to develop without being stopped out too early.
For instance, if the ATR value comes out to be 1.88, multiply it by 1.5 to get about 2.82. Therefore, at a certain distance of about 2.82 units from the entry price, that’s where you should place your stop-loss.
Advanced ATR Strategies: Dynamic Trailing Stop-Loss with ATR
The ATR indicator can also be used to trail stops that adjust as the trade moves in your favor. As a dynamic way to trade, a trader is able to lock in profit while his trade has room to grow at the same time.
Employing ATR for Trailing Stops
- Choose an ATR Trailing Stop Indicator: Some trading platforms have ATR trailing stop indicators built in. They automatically set your stop-loss on the basis of the changed current ATR value.
- Adjusting the Period and Multiplier: You can change the period and multiplier of ATR to match your kind of trading. The lower the multiplier, the tighter the stop-loss will be; the higher, the more allowance there is.
- Shielding Your Stop-Loss: As the trade moves forward, your stop-loss will trail the ATR, ensuring that no huge loss can be incurred, thereby locking in profits and minimizing losses.
Benefits of Using the ATR Indicator
- Less Likely to Get Stopped Out: Placing a stop-loss consistent with market volatility means you are less likely to get stopped out just because of random market noise.
- Adaptive to Market Conditions: The ATR itself changes with the market’s volatility and is, therefore, quite an adaptive tool across various market conditions.
- Better Trade Management: ATR for trailing stop-loss helps you manage trades effectively. You can increase or decrease the level of risk once the trade moves in your favor.
Common Mistake and How to Avoid Them
- Over-reliance on the ATR: The ATR can be a very powerful tool, but it should work in combination with others. Combine it with other indicators and analysis to form a comprehensive trading strategy. When setting your stop losses, always consider the wider market. News announcements, timing of economic data releases, and unexpected market developments can all change the volatility and thus need to be factored into your thinking.
- Misconceptions About ATR Values: Remember that ATR itself only shows the average movement in price and does not give any indication of price direction. Use it for guidance, not as an absolute forecast.
Conclusion
Stop-loss placement is a critical part of trading, and the ATR indicator provides a reliable method for placing your stop-loss at an optimal level. Understanding and applying the ATR enables you to protect your trades better, avoid early exits, and manage your risks in a manner that is commensurate with market volatility. The next time you’re unsure where to place your stop-loss, remember that the ATR can measure this for you. Incorporate it into your strategy, and you’ll be trading with more confidence and precision.
If you’re still struggling with where to place your stop-loss, add the ATR indicator to your next trade and see the difference it makes. As always, mind the news, practice proper risk management, and trade well.
