Using Average True Range As A Stop

By July 16, 2016 Newsletter No Comments

I am going to share about average true range. One truism held by traders: “It is not when you buy, but when you sell that really counts.” Of course skill is needed in order to find good stocks to trade. And of course, making a good entry can certainly reduce your risk. But at the end of the day, the success of the trade is in the profit you take home and that is where a good exit strategy is a must.

Average True Range

Static stops like a 5% stop loss or a 10% profit target are good starting points. However, for profit targets, especially, there is nothing more frustrating than setting your target only to watch the stock reverse just before reaching the target and then hit your static stop loss to take you out of the trade for a breakeven, or worse – a small loss.

There are a number of ways to implement money management rules to avoid this situation. One such way is to use a trailing stop that will move with the market as it advances but will stay static if the trade moves against you. A popular method is to trail the stop based on the low for long trades and the high for short trades or the open or previous day’s close can be used. The only problem with this type of trailing stop is that you have to move and set the stops manually each day, since there are very few trading platforms that can do this for you automatically. Some more automated solutions would be: price trailing stops, percentage trailing stop, and volatility trailing stop.

A price trailing stop uses a fixed price distance to trail each bar’s stop. This is useful especially where you may want to limit your stop distance to a fixed predetermined value, i.e. $0.50, $1.00, $5.00 etc. One draw back of this stop is that $1 could be a large move for one stock and very small move for another. This is why the price trailing stop should mainly be used on individual stocks whose movement is well known to a trader.

For stocks with similar volatility levels, the percentage trailing stop can offer better results. Here you can start with say a 5% stop loss, but have it trail with the market higher while allowing for inter-day and intra-day volatility. However, similar to the price trailing stop, for some stocks a 5% is a large move, and for others not so large.

A third option is the volatility trailing stop. As the name suggests the stop distance is matched to the volatility of the individual stock. A trader can obtain this information by checking the ATR (Average True Range) indicator. For those not familiar with Average True Range, the indicator measures the opening and closing prices each day over a 14 to 30 day period. It then averages out the movement to provide the average daily trading range for the stock. This ensures that whether the stock usually moves 1% or 10% daily, it will not whipsaw you out of the trade on normal trading movement.

The best stop strategy and settings are best left up to you and your risk tolerance. I even know a number of traders that use a combination of strategies. They initially use a price stop to keep losses small in case they made a mistake on the entry. But then, once the trade is showing a profit, may give it more room using a percentage stop.

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