A Practical Look at Implementing an ATR-Stop loss
As we all know, trading involves many components, and one of the most crucial elements we quickly realize in our trading journey is the importance of a stop-loss. I like to think of a stop-loss as the point where my trading system tells me that my initial entry setup’s probabilities and risk-reward are no longer valid. Signaling, that continuing with the trade from this point may carry additional risk, prompting the question: Do you want to continue or exit?
So, how do we set this stop-loss? How do we determine the right level to exit the market? Is there a “perfect” stop-loss level? The truth is a simple NO. There isn’t a holy grail for stop-losses and that’s just the unpredictable nature of the market.
However, we can still use tools to contextualize the fluctuations around our entry levels. One such tool is the Average True Range (ATR) , which helps us establish stop levels in line with market volatility, where the stop level is based on the volatility of the assets rather than using a fixed percentage, giving a more dynamic approach.
How to use the ATR for Stop-loss levels
There are countless ways to apply an ATR stop to a trading system. For this tutorial, I’ll walk through the two most common approaches, which can be seen as building blocks for further refinement.
The ATR stop consists of two key parts:
The ATR stop consists of two key parts:
- The ATR Value – A measure of the typical volatility in price.
- The Multiplier – A value used to multiply the ATR based on your desired risk level.
The general formula for calculating stop-loss is:
-
For a long position:
Stop-loss level = (Close Price or Entry Price ) – (ATR Value * Multiplier) -
For a short position:
Stop-loss level = (Close Price or Entry Price ) + (ATR Value * Multiplier)
Example:
Now, suppose we have a stock with an ATR of 4, a previous close of 125, and your entry trigger for a long position is at 127, here’s how to calculate stoploss based on the fundamental methods.
Method 1 - Stop-Loss Based on Close Price
This approach uses the previous close as a reference point for setting the stop-loss:
= Stop-loss level
= Close Price – (ATR * Multiplier)
= 125 – (4 * 1)
= 121
Key Consideration:
Since the stop is based on the close price and not your entry, this could result in needing a higher risk-reward ratio to account for the gap between the close price and entry. For example, if you entered at 127, your stop at 121 might now be further from your entry than you would prefer, requiring larger price movements for you to have a “good” risk-to-reward ratio.
Method 2 - Stop-Loss Based on Entry Price
The stop-loss is calculated relative to your entry price:
= Stop-loss level
= Entry Price – (ATR * Multiplier)
= 127 – (4 * 1)
= 123
Key Consideration:
Since the ATR value is based on the previous close price, using the entry price to set the stop-loss might result in a smaller stop-loss. For example, if the ATR was calculated from a close price of 125 and the market has since moved up to 127, your stop-loss level at 123 is closer to the entry price than a stop-loss based on the close price (121). In a volatile market, this could mean the stop is tighter than expected based on average fluctuations, potentially leading to an earlier exit from the trade.
ATR Multiplier
The ATR Multiplier is a factor used to adjust the Average True Range (ATR) by multiplying the ATR by a specific value. A higher multiplier sets a wider stop-loss, while a lower multiplier creates a tighter stop-loss. The multiplier allows you to customize the stop-loss distance to better match the volatility of the asset and your risk management strategy.
Continuing with the Method 2 example, a stop loss level with an ATR Multiplier of 2 would be calculated as follows:
=Entry Price – (ATR * Multiplier)
=127 – (4 * 2)
=119