Using Average True Range to Set Stops Correctly

A twenty pip stop is a different trade in different conditions. In a quiet week it sits well outside normal movement. In a volatile one it sits inside the noise and gets removed by nothing in particular.

Using average true range to set stops correctly addresses that by making the distance proportional to what the instrument is currently doing rather than to a number you chose once.

What It Measures

True range is the greater of three distances. The current bar’s high to low, the high to the previous close, and the low to the previous close.

The last two exist to capture gaps. A market opening well below yesterday’s close has moved further than its own bar suggests, and true range counts that where a simple high minus low would not.

Average true range smooths that over a number of periods. It describes typical movement including gaps, which is why it suits stop placement better than plain range.

The Multiplier Should Come From Your Own Trades

Common practice is one and a half to two times ATR, and those figures get quoted as though they were derived from something. They are conventions.

The honest method is measurable from your own history. Look at your winning trades and find how far each one went against you before it worked. That distance, expressed in ATR, is the distribution your stop needs to survive.

If your winners rarely move more than one and a quarter ATR against you, a two ATR stop spends the risk budget on protection you never use. If many reach one and three quarters, a one and a half ATR stop cuts winners before they resolve.

That takes an hour and replaces a convention with a number describing your actual strategy.

It Does Not Replace Structure

An ATR stop is a distance, not a location.

Placed mechanically it can land in the middle of open space, or worse, just inside an obvious level where a dense cluster of other stops is already sitting. Distance says nothing about what price will encounter on the way.

The workable combination uses structure for placement and ATR to check the result. A structural stop at half an ATR sits inside normal noise and gets hit by ordinary movement. One at three ATR makes the trade too large to size reasonably.

Structure decides where. ATR says whether that is sensible.

Your Position Size Has to Move With It

This is the part traders skip and it matters most on a funded account.

Risk per trade is stop distance times position size. If the stop tracks ATR and ATR doubles, holding your lot size constant doubles your risk per trade.

So an ATR stop without a size adjustment produces exactly the wrong outcome. Risk expands in volatile conditions, which is when drawdown room is already under pressure.

Size has to be recalculated every trade, inversely to the stop distance. Wider stop, smaller position. That is the entire point of a volatility adjusted stop and it only works if the second half is applied.

It Lags at Turning Points

The limitation is worth knowing.

ATR is backward looking. After a volatility expansion it is still catching up, so stops are too tight exactly when movement has increased. After a contraction it stays elevated, so stops are too wide and positions too small.

It describes the recent past accurately and the next hour approximately.

Conclusion – Using Average True Range to Set Stops Correctly

Using average true range to set stops correctly means deriving the multiplier from your own winning trades rather than from convention, using structure to decide placement and ATR to validate the distance, and recalculating position size every time the stop distance changes.

FAQ – Using Average True Range to Set Stops Correctly

1. What ATR multiplier should I use?

Whatever your own winning trades require. Measure how far they moved against you before working, expressed in ATR.

2. Should I use ATR or structural stops?

Both. Structure decides placement, ATR tells you whether that distance is reasonable for current conditions.

3. Does my position size change with ATR?

It must. If the stop widens with volatility and your size stays constant, your risk per trade grows exactly when conditions are worst.

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Additional resources:

ATR (Average True Range): Complete Trading Guide 

ATR Indicator: How to Use Average True Range for Stop Losses | Risen