Finding the perfect spot to place your stop-loss order can be a difficult challenge.

If you make your stop too tight, you run the risk of being wicked out of the trade before price moves in the direction you actually wanted it to move; leaving you with a loss when you should have had a gain.

Set the stop too wide – and you run the risk of taking a much larger loss than you might have wanted.

This pattern of confusion leads many traders to indecision; and in some cases direct obstinance as some traders ignore placing stop-loss orders on their trades altogether. As we saw in The Number One Mistake that Forex Traders Make – this can be a dangerous way of trading, and can lead many traders down a very costly path.

This is where ATR, or Average True Range can greatly assist traders in these situations.

What is ATR?

Average True Range is an indicator designed to assist traders in reading volatility. As volatility increases or decreases, so will the value of ATR. The chart below will show AUDUSD with ATR applied:

Managing Risk with ATR

Created with Marketscope/Trading Station II

In the chart above, notice the green area highlighted on the price area as well as the bottom portion of the chart.

As price began making smaller movements in the green box, the indicator below the price chart properly reflected this waning volatility.

ATR moved smaller to reflect the lessened volatility in price.

Also notice the reading for ATR in the upper, left corner of the indicator; and if you couldn’t see it in the chart above, the picture below will illustrate further:

Managing Risk with ATR

Created with Marketscope/Trading Station II

The reading on ATR is at .00285. This is in ‘pips,’ expressed in the same price format as the currency pair.

So, for a currency pair like AUDUSD, in which price is at 1.0436 at the time of this writing – an ATR reading of .00285 is 28.5 pips.

If ATR were at .00418, that would be 41.8 pips. And if ATR is at .01295, that would be 129.5 pips.

ATR will always be expressed in the format of price.

Setting Stops with ATR

After a trader knows how to read ATR, much of the legwork in using the indicator is already done. As we saw in the 4-hour chart above, ATR was reading 28.5 pips on AUDUSD.

As traders enter AUDUSD positions, they can look to set stops at 28.5 pips – or the value of ATR at the time of the trade’s initiation.

If this stop level feels as though it may be too close to current market price, traders can look to customize their approach in being more conservative or aggressive; setting their stops at multiples of the ATR reading.

A trader looking to be more conservative (in using a larger stop) could set their initial risk level to two times the ATR reading. If this is the case, the trader looking at opening an AUDUSD position from the scenario above would be looking at a stop of 57 pips (28.5 X 2 = 57).

On the other hand, a trader wanting to be more aggressive can look to set ATR at ½ of the Average True Range value. In the above AUDUSD example, that would be a stop of 14 pips (28.5/2 = 14.25 (rounded down)).

--- Written by James B. Stanley

You can follow James on Twitter @JStanleyFX.

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The ABC’s of Risk Management