Use ATR in setting stops
TO KEEP out of the red, traders need to watch out for market volatility. Average True Range (ATR) is a handy weapon in the trader’s arsenal, helping to determine where to set good stop losses.
ATR is simply the average difference between highs and lows over a user specified period, explains Malcolm Pryor of www.spreadbettingcentral.co.uk, although he adds that in practice it is slightly more complicated, with adjustments needing to be made for gaps and previous averages. ATR was first described by trading legend Welles Wilder in his 1978 landmark book, New Concepts in Technical Trading Systems. Another living legend, “Prince of the Pit” Richard Dennis, also uses ATR, as do his “turtles,” the notorious novices Dennis successfully trained from scratch.
For Manoj Ladwa of ETX Capital, ATR is an excellent measure of volatility because it takes into account the daily range of the underlying asset. It is mainly “used to aid stop placement rather than as a tool on its own,” which “can help the trader be consistent in stop placement with respect to the volatility of the instrument,” says Pryor. The first thing that a trader needs to decide is the ATR period they are going to measure. Ladwa says, “traders should judge the period measured depending on how sensitive they want it. But if the figure is too low, readings will be erratic.”
“For trades expected to last six months, one might select three times the daily ATR, while for trades expected to last between two and 20 days I personally like to use one time the highest ATR reading of the last six months,” says Pryor. “Typically traders look at ATR values and set stops from two to four times the ATR value,” says Ian O’Sullivan of Spread Co. The multiple used depends on the length of trade, the risk profile of the trader and their objective.
O’Sullivan warns that ATR “is not a leading indicator sending signals about potential market direction, it just gauges price volatility.” Pryor suggests that for practical trading strategies trying to exploit changes in volatility, Bollinger Bands are more useful. Ladwa notes “readings can vary widely day to day,” so he advises that position traders adjust the ATR once a week and for day traders to note the value at the start of the day. As with all moving day averages, Pryor points out that it has the minor weakness of being a lagging indicator. To manage this problem he suggests not selecting periods that are too large.
Without volatility, traders cannot trade; too much and they can get easily stopped out. ATR helps prevent traders turning turtle when the market waters are choppy.