Many traders feel the world is against them as far as setting stop losses is concerned. It becomes so frustrating to enter a trade only to get stopped out, repeatedly making it look like the market is targeting you directly.
Technical analysts who rely on indicator-based readings in platforms such as MetaTrader or Trading View can benefit a lot from knowing how to use indicators effectively to enhance trading strategies.
In this article, we will discuss how to use the Average True Range (ATR) indicator to set more effective stop losses, reducing the frequency of being stopped out prematurely and improving overall trading performance.
Understanding the Average True Range (ATR) Indicator
The Average True Range (ATR) is a popular technical analysis tool that measures market volatility by decomposing the entire range of an asset’s price for that period. It provides traders with an idea of how much the price of an asset can fluctuate, helping them set appropriate stop losses.
How the ATR Works
The ATR computes the average range of price fluctuations for a set time. The average range gives a trader an idea of the level of volatility, showing the typical price fluctuation of an asset in a particular period. Assuming that the ATR is 8 pips, this implies that the price is expected to go either upwards or downwards by 8 pips.
Use of the ATR to Determine Stop Losses
Step 1: Add the ATR indicator to your chart
Open your trading platform and go to the chart of the asset you are evaluating, for instance, EUR/USD.
Click the ‘Indicators’ tab.
Type in ‘ATR’ then select the Average True Range built-in indicator.
Change the settings to appear with optimal visibility, for instance, change the line color and line thickness.
Step 2: Determining Stop Loss Distance
Using the ATR, a trader can set the stop loss multiple times the value of the ATR to leave more room in the trade. For instance, if the ATR is 3.6 pips, setting a stop loss at 1.5 to 2 times the ATR, meaning 5.4 to 7.2 pips, will decrease the chances of being stopped out due to normal market fluctuations.
Step 3: Adjusting for Volatility
Markets can be quite volatile, and ATR assists with dynamic adjustments in stop losses. When the market is very volatile, the value of the ATR will be higher, implying a wider stop loss. During low volatility, the ATR will be smaller, implying a tighter stop loss.
Sophisticated ATR Strategies
Using ATR Trailing Stops
In your trading platform, find ‘Average True Range Trailing Stops’ in the public library of indicators.
Select a version with graphics, such as the ‘ATR Trailing Stops Colored by H Potter’.
Settings
Select the ATR period to 5.
Adjust the multiplier to 3.5 for more reliable trailing stops.
Change the line style for better visibility.
This advanced tool places dynamic trailing stops on the chart, which helps you manage trades better. The stops move with the market, so your stop loss is always kept at a safe distance from the current price action.
Combining ATR with Other Indicators
The ATR is very powerful on its own, but combining it with other indicators like Moving Averages (MA) can enhance your strategy:
Adding Moving Averages:
Search for ‘SMA’ in the indicators tab and add it to your chart.
Use short-term (e.g., 9-period) and long-term (e.g., 21-period) MAs to identify trends.
Confirming Trends:
If the price is above the MAs and the ATR is rising, it suggests a strong uptrend. Set stop losses below the ATR trailing stop line.
If the price is below the MAs and the ATR is rising, it is likely in a downtrend. Set stop losses above the ATR trailing stop line.
Real-life Application: EUR/USD
Let us take the example of EUR/USD:
Current Price: 1.1783
ATR: 3.6 pips
Long position:
Enter a long trade at 1.1783.
Set a stop loss at 7 pips that is, 2x ATR, i.e., at 1.1776.
Set a take profit at a reward-to-risk ratio of 2:1, i.e., 14 pips away at 1.1797.
This method will avoid getting stopped out by small moves in the market, which will improve the chance of making a successful trade.
Some Common Mistakes and How to Avoid Making Them
Ignore Volatility: Always account for the value of ATR. The static stop loss will ensure frequent stops when the market is volatile.
Setting Too Tight Stop Losses: Make sure the trade has some space to breathe. Too tight a stop loss ensures more stopped trades.
Not Using a Stop Loss: Always use a stop loss to manage risk. The ATR helps in setting it at a logical point.
Using the Average True Range (ATR) indicator effectively can transform your trading strategy by helping you set stop losses that are aligned with market volatility. By integrating the ATR into your trading routine, you can reduce unnecessary losses and improve your overall profitability. Remember that the trading business is as much about reducing losses as making gains. You would do best by using an ATR and applying it to your Moving Average or other moving averages, allowing smartly set stop losses so that you last longer and become stronger in trading.
