Day Trading: ATR Stop Loss

Setting a stop loss point is probably the most important rule a trader needs. Share trading is a game of chance, and it's only natural to hold on to losing trades. Using stop losses will minimise risk that you will sink with the ship and lose all your capital.

Aside from hard stops, many traders find using an ATR (average true range) stop efficient. The average true range is a moving average (14-days) that measures volatility over time, but not price direction. When using ATR stops, the stop length (usually 14) is marked by the average true range percentage.

A high ATR means high volatility and a lower ATR means lower volatility. So why use an ATR stop rather than a hard stop? Generally, a hard stop does not take into account market volatility. A hard stop remains the same value under volatile and stable market conditions. Using an ATR stop ensures that your stop remains variable depending on volatility.

For example, let's say the AUD/USD average daily range is around 120 to 160 pips. Trader X uses a 10 percent ATR stop, placing 10 percent x ATR pips from the entry price. This makes the stop at 12 to 16 pips from the entry price. Trader Y, on the other hand, uses a 50 to 100 percent ATR stops. The following month, daily ATR rose to 160 to 190 pips. Therefore, day trader X with a 10 percent stop would have stops at 16 to 19 pips, while Trader Y would have stops at 80 to 95 pips from entry.

ATR Stop vs the 2 Percent Rule

The "2 percent rule" is used to determine position size to limit total losses given a certain stop position. When buying a share, ATR is used to determine the initial stop position. Once loss per share is calculated when the stop is triggered, you can use the 2 percent rule to figure out how many shares to buy. That is, you keep your capital losses under 2 percent once you hit the stop. As 2 percent can be enormous on larger trades, most traders find using 1 to 1.5 percent stop limit on capital.