Today we look at the use of the average true range stop loss placement.
The ATR indicator tells us that the “Average True Range” of a stock price movement is based on the movements of the previous candlesticks.
Lots of investors, be it stock investors or Options investors, use the ATR indicator to aid in your stop loss placement. Let’s discuss why and how to do this:
The typical period in which the ATR indicator looks back is 14 periods. Although this setting can be adjusted.
When we look at a daily newspaper Candlestick chart, the ATR calculation is based on the price movement over the last 14 days.
If we look at a weekly chart, the ATR calculation is based on the last 14 candles, so each candlestick is a trading week.
The precise definition of ATR is that it is the simple moving average of the “true range” of a stock. As a result, the true range is the greatest of the three:
a) current high minus current low
b) absolute value of the current high minus the previous closing price
c) absolute value of the current low minus the previous closing price
You don’t really need to know how this is calculated as each charting package does this calculation automatically.
Conceptually, ATR is low when price movements are small, such as B. when consolidating with small overlapping candles and short Doji candles.
ATR is high when Volatility is increased and we see long tall candles (red or green).
The Average True Range is high when a stock makes large moves up or down.
The ATR does not show any direction, it just measures the size of the movements.
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By using Average True Range for stop loss placement, we take that into account volatility of the respective share at a specific point in time.
The ATR value differs depending on the time frame of the graph. Above, we take a look at the daily chart of the S&P 500 ETF (SPY), which currently has the ATR at 5.
In the following, we will look at SPY using a weekly chart in which each candle represents a trading week.
The ATR indicator below shows a value of 11.6.
Have different stocks different volatility and prices.
Tesla (TSLA), for example, costs around $ 600 with typical ATR values of 35.
Walgreens (WBA) is around $ 55 per share with a typical ATR of 1.5.
The placement of a stop loss with TSLA differs from that with WBA.
Therefore, we want to place a stop loss far enough away that normal price fluctuations will not stop it.
The ATR determines the range of these normal fluctuations based on the price of the stock, the volatility of the stock at that point in time, and also the time frame in which you are trading.
A typical choice of stop placement is an ATR below the low of the entry candle or the candle before it, depending on whether you enter it towards the end of the market day or whether you enter it at the beginning of the market day.
For example, suppose an investor notices on January 19, 2021 that the price of American Express (AXP) breaks out of the resistance level of $ 126.
The investor decides to buy if the price rises above the high of this break-out candle the next day. A buy stop limit order is placed to buy AXP when it breaks above $ 128.6.
Sometime the next day on the 20th the price soared all the way up to $ 128.6 and the Ordering shares is filled.
The investor sees this after the market closes and now decides where to place the stop loss.
As a result, the investor places the stop loss at an ATR below the low of the entry candle.
Date: January 20, 2021
Bought price: $ 128.60
Lowest value of the entry candle: $ 127.10
Stop loss: $ 123.9 (127.10-3.20)
Maximum risk per share: $ 128.60 – $ 123.90 = $ 4.7
Profit target at 1.5 x risk: $ 128.60 + $ 1.5 x $ 4.7 = $ 135.7
This turns out to be a failed breakout and the investor will be stopped on January 25 if the price of AXP falls below $ 123.90.
Another investor (or the same investor) opts for shortout defaults.
The investor sees the price open on January 25th below the low of the previous candle.
The price falls back into the trading range of AXP after the failed breakout.
The investor empties the stock at $ 124.00.
Since this is the case when the market opens, the investor reads the previous day’s ATR to see that it is $ 3.10. The investor also applies the stop loss based on the previous day’s candle high (which is $ 127). Since $ 127.0 + $ 3.10 is $ 130.10, the investor places a buy order to cover if the price exceeds $ 130.10.
This limits the maximum loss to $ 6 per share.
Different investors have different risk / return targets.
Some prefer a high risk-to-risk ratio like 2 to 1.
Others may prefer higher probability trades with a smaller risk-to-risk ratio of 1.25.
Suppose the investor sets a risk-risk target of 1.4 in this case. That would mean that the investor would take profits if the price fell to $ 115.60.
Calculated at $ 124 – 1.4 x $ 6 = $ 115.60.
The price dropped to $ 115.60 on Jan. 27, and the investor benefited from $ 8.4 per share.
An options investor may want to use options to short the same breakout error.
It’s a reasonable bet that the price is unlikely to go above $ 130, which is slightly higher than the high the price hit before the failed breakout.
The investor places a Spread the bear call with the short strike at $ 130.
Date: January 25, 2021
Price: AXP at $ 123.73
Sell two AXP $ 130 calls on Feb 19th @ $ 2.25
Buy two on Feb 19th AXP $ 140 Call @ $ 0.56
Recognition: $ 338
The option investor can continue to apply his normal rules, such as: B. Profit-taking at 50% of the premium and stop-loss at once the premium, or whatever its rules are.
In addition, however, the investor manages the trade based on price action.
If the price exceeds $ 130, the investor can end the trade early instead of waiting for the options stop loss to be reached.
If the price rises above $ 130, it already means that the investor’s original thesis for trading is wrong.
If the price makes a large move at the start of trading, where the price hits the forecast target of $ 115.60, the investor can simply take the profit with it.
In this case, the 50% of the premium received will be reached before the target price is reached. Definitely take the profit, whichever comes first.
Since breakouts fail sometimes, some investors prefer to go long on breakouts after retesting the support and determining that the support is holding.
While this increases the success of trading the outbreak, there are fewer occasions when this occurs.
This pattern occurred at Chevron (CVX) on March 1 when price opened above the hammer retesting support.
Date: March 1, 2021
Price: CVX opened at $ 102.46
ATR of the previous candle: 2.84
Low of the previous candle: $ 97.61
Stop loss: $ 97.61 – $ 2.84 = $ 94.77
Risk per share: $ 7.69
Goal 1.4 x risk: $ 102.46 + 1.4 x $ 7.69 = $ 113.23
The option investor goes long with a Call Debit Spread where the long strike is around where the stop loss is and the short strike is around the target price.
On April 1st, buy a CVX $ 95 call @ $ 9.10
Sell a $ 115 CVX Call on April 1st @ $ 0.80
Direct debit and maximum risk: $ 830
Maximum reward: $ 2000 – $ 830 = $ 1170
Reward-Risk Ratio: 1.4
Note that the risk / return ratio is roughly the same as that of a stock investor – assuming the investor holds to expiry.
In order not to risk any risk allocation, the investor decides to take a profit of $ 585, which is 50% of the maximum reward.
The investor chooses to exit trading if the loss exceeds $ 415, meaning 50% of the original investment is lost.
Since we are reducing the profit by 50% and the losses by the same 50%, this does not change the risk-to-risk ratio: $ 585/415 = 1.4
On March 11, the profit target of $ 585 was met.
In this example we see that we can use options to mimic the same risk / return ratio as the stock investor while using much less capital.
The ATR is also used to track stop loss by moving the stop up when the stock rises.
For example, let’s say an investor buys Goldman Sachs (GS) on February 2, 2021 after retreating in an uptrend.
The stop is placed one ATR below the low of the previous candle.
When investors see profits equal to 1.4 times the current risk in trading, the investor increases the stop loss.
While some investors may expand the stop loss to 2 ATRs at this point in order to track a longer term trend, let’s keep things simple and keep the one ATR stop loss.
The stock continues to rise and the stops are raised as shown until the investor was stopped out on March 25th.
Using Average True Range stop loss placements is a more objective way of setting stop losses than setting it visually by observing the chart.
It looks at that Volatility movement of the stock.
In the last example we see that the stops are sometimes wider or narrower, although we always use an ATR stop.
This is because the ATR changes with the price change. During trading, the ATR moved from a low of 7.1 to a high of 9.7.
The investor has a great deal of discretion. Some will want larger or smaller ATR stops.
Some want smaller or larger goals and so on.
There is no one right answer as it depends on many factors, such as: B. the type of market at the time and the trading style of the individual investor.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.