In our last lesson we looked at determining how much you are willing to risk on any one trade as the first step in developing a successful money management strategy. Now that we have established this, in today’s lesson we are going to look at some of the different ways that you can then set your stop, which fit within this initial criteria.

As we learned in last lesson, risking more than 2% of total trading capital on any one trade is a major reason for the high failure rate of most traders. Does this mean that when setting a stop we should simply figure out how many points away from our entry represents 2% of our account balance and set the stop there? Well, traders could obviously do this and to be honest it would probably be a lot better than most of the other money management strategies I have seen, but there better ways.

Although many traders will look at other things in conjunction, having an idea of the historical volatility of the instrument you are trading is always a good idea when thinking about your stop loss level. If for instance you are trading a $100 stock which moves $5 vs. a $100 stock that moves $1 a day on average, then this is going to tell you something about where you should place your stop. As it is probably already clear here, all else being equal, if you put a stop $5 away on both stocks, you are going to be much more likely to be stopped out on the stock which moves on average $5 a day than you are with the stock that moves on average $1 a day.

While I have seen successful traders who get to know a list of the things they are trading well enough to have a good idea of what their average daily ranges are, many traders will instead use an indicator which was designed to give an overview of this, which is known as the Average True Range (ATR)

Developed by J. Welles Wilder the ATR is designed to give traders a feel for what the historical volatility is for an instrument, or very simply how much it moves. Financial instruments that exhibit high volatility move a lot, and traders can there fore make or lose a lot of money in a short period of time. Conversely, financial instruments with low volatility move a relatively small amount so it takes longer to make or lose money in them all else being equal.

As with many of the other indicators we have studied in previous lessons, Wilder uses a moving average to smooth out the True Range numbers. When plotted on a graph it looks as follows:


What you are basically seeing here is a representation of the daily movement of the EUR/USD. As you can see when the candles are longer (which represents large trading ranges and volatility) the ATR moves up and when the candles are smaller (representing smaller trading ranges and volatility) it moves down.

So with this in mind, the most basic way that traders use the ATR in setting their stops is to place their stop a set number of ATR’s away from their entry price so they have less of a chance of being knocked out of the market by “market noise”.

That’s our lesson for today. In tomorrow’s lesson we are going to look at how you can use volatility based stops in conjunction with another method traders use for setting stops based on technical levels so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together and good luck with your trading!

Hi David:

Appreciate your series very much - wish I hadn't learned much of these lessons the hard way! Just wondering about the struggle between keeping the rule of thumb not to risk more than 2% on any position AND using ATR as per your video. On many stocks, ATR or two ATRs represent much more than 2% (like in your $100. example with $5 regular movement) - if one uses that, aren't we raising our risk tolerance beyond the rule of thumb? I understand that we want to allow for regular movement of the stock, but how does this protect us from losing far more than we should?? Thanks.

Hi Iceman,

Thanks for the comment am glad you like the videos.

First I want to make sure that we are clear that the 2% that I am talking about is not risking more than 2% of your overall trading capital not 2% of the value of the stock that you are trading.

With this in mind yes there are a lot of stocks out there that with all but very high account values setting a stop 1 or 2 atr's away to get away from random market noise will represent more than a 2% loss of the account. My answer here would be that if a trader wishes to use proper money management rules then he will not be able to trade those stocks and should focus on less volatile stocks which will allow him to stick within the 2% rule.

Hope that helps. If there are any other questions or comments here please leave them in the comments section below.

Best Regards,
Dave

Dave,

I've been playing around with a demo FOREX account and I've set my stops not more than 2% of my account, but primarily around support / resistance levels. I now understand why some of my positions get stopped out in an hour or two, while a position (like an NZD/USD I'm holding right now) has gone for about 8 hours.

I need some clarification though - the 14 period ATR for the NZD/USD 60 minute chart is 0.00134. Does that mean 134 pips is the ATR?

Thanks for the help! Great lesson!

James

Hi James,

Glad to hear from you and it sounds like you are making some good progress there.

Remember however that a 1 pip move in the NZD/USD is a move from .0001 to .0002 or in other words 1 up or down at the 4th decimal place. So with this in mind a reading on the ATR of .00134 on the hourly chart is a reading of an Hourly ATR of 13.4 pips.

Hope that helps. Feel free to post if there are any other comments or questions on this one.

Best Regards,
Dave

Great Threads.

I will need some time to catch up reading past topics.

Thanks for sharing.

hi dave
i need to ask how to calculate the 2 atr as my stop limit

Hi bahrawy21,

Glad to hear from you.

The first thing that you will want to do is place the average true range (ATR) indicator on the chart of the indicator that you are trading. On most charting packages, when you run your mouse over the indicator it will give you the value of the indicator for the point on the chart where your mouse is.

To get the current value of the ATR you will want to move your mouse over to the current bar which will give you the current value of the ATR. Once you know this you simply multiply by two.

Hope that helps. As always if you have any other questions or comments please feel free to post.

Best Regards,
Dave

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Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.