How to use the average true range to place your stops
Summary: The average true range (ATR) is often seen as one of the best technical analysis indicators. Not only does it measure market volatility, but it also helps you identify where to set your stop-loss and reduce the risk of being closed out prematurely.
The ATR, developed by J. Welles Wilder, is considered to be the most accurate volatility indicator. As opposed to other volatility oscillators, it paints the true picture by capturing the entire price range of an asset and factoring gaps into its calculation. More specifically, the true range is defined as the greatest of the following:
A. Current high less the current low
B. Current high less the previous close (absolute value)
C. Current low less the previous close (absolute value)
Calculating the ATR
The ATR is based on a chosen period and is calculated on either an intraday, daily, weekly or monthly basis. The most common approach is to use a 14-day period on a daily chart, where the ATR is the average of the daily true ranges within the last 14 days.
Using the ATR to set your stop levels
Although the ATR was originally developed for commodities, you can also apply it to stocks, indices and forex.
One way to use the ATR is to identify your stop-loss level, and a common strategy is to set your stop-loss one ATR from your entry position. For instance, if you sell 20,000 EURUSD at 1.0958 and the ATR-14 is 198 pips, you would set the stop-loss at 1.1156. You can see this illustrated in the chart below. If you’re a more conservative trader, you may want to set your stop-loss at 2x or 3x the ATR from your entry point.
Another strategy is to set your stop-loss one ATR from the nearest support or resistance level. By doing this you give the trade room to breathe and lower the risk of getting closed out from volatility spikes through your resistance or support. In the example below, the US500 was sold with a stop-loss placed one ATR-6 above support on a four-hour chart (ATR-6: 24 hours, 6 periods x 4 hours).