Using an ATR Trailing Stop Indicator for Spotting Trends and Reversals

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Using an ATR Trailing Stop Indicator for Spotting Trends and Reversals

The Average True Range Trailing Stop indicator is great for traders who need help spotting the trend, or need an indicator that can help them choose in which direction to place trades. The indicator also points out pullbacks that are strong enough to warn that the current trend may be in danger.

Average True Range (ATR)

Average True Range is a volatility measure which assigns a value based on the high of a price bar minus the low, or the high or low minus the previous close, whichever value is greater. This volatility is then averaged over a number of periods (price bars), such as 12 or 22 price bars.

The ATR is calculated as a price, so a reading of 0.5 means $0.50. It means that on average the price is moving about $0.50 each price bar. In forex the ATR will be measured in pips, so a reading of 21 means the price is moving about 21 pips, on average each, price bar.

ATR is a running calculation which means the indicator will continually produce new values based on new information. For more on ATR, see: Two Powerful Indicators and How I Use Them.

Average True Range Trailing Stop

Applying the ATR Trailing Stop to your chart creates a line which is either above or below the price.

When the indicator is above the price it signals the trend is down, and if the price moves above the line the trend may be in danger of reversing.

When the indicator is below the price it indicates the trend is up, and if the price moves below the line the trend may be in danger of reversing.

Figure 1 shows the ATR applied to a 3-minute chart of Apple (AAPL) stock.

Once morning volatility subsided the price moved out of a brief uptrend and into an extended downtrend. When the downtrend began the indicator flipped on top of the price and stayed there throughout the entire decline.

This could have provided confirmation to traders that taking short position, or buying puts, was the ideal play.

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Just after 13 (1:00), the price breaks above the ATR Trailing Stop, and sets in motion a potential uptrend. The price didn’t actually enter an uptrend, rather it moved sideways, yet the indicator would have warned traders that the downtrend was no longer in effect.

This is actually isn’t a trend-change indicator though. When the indicator “flips” all it means is that a larger than usual pullback has occurred. Sometimes, that means a trend change, other times not. Price analysis is also need to confirm trend changes. This indicator simply warns you that a larger than average pullback has occurred, and some caution is warranted.

The indicator in figure 1 is taking a 22-period moving average, and then multiplying it by 3. Therefore, behind the scenes, the indicator is calculating the current 22-period ATR, multiplying it by 3, and then adding it to the current price in the case of a downtrend, or subtracting it in the case of a downtrend. This is what creates the separation between the line and the current price.

Decreasing the settings will make it more sensitive to trend changes, but potentially false signals as well.

Increasing the settings will make the indicator less prone to false signals, but will be more delayed in spotting potential trend changes.

The indicator works best in trending markets. When the price action is choppy, the indicator will flip-flop above and below the price, not providing a lot of useful data.

The indicator is based on the closing prices of bars. Therefore, ideally if using the indicator you will need to wait for price bars to close before acting on any information the indicator may provide. Figure 2 shows a choppier day in Apple stock. Notice in the oval how the price breaks below the ATR Trailing Stop line on several occasions, but since the bars don’t close below the line, the uptrend remains intact.

Another pitfall, which is not the indicator’s fault, is that it is not as common as some other indicators, and therefore may not be available on all charting sites or platforms.

The ATR Trailing Stop indictor can help you trade in the direction of a trend. If it helps you, use it as a guide while you trade. For providing specific entry signals it isn’t ideal, rather it provides confirmation of the trend. When the indicator “flips” from uptrend to downtrend (or vice versa), use price analysis to determine if there is an actual trend change, if it was just a deep pullback or if the price is moving sideways.

Enter Profitable Territory With Average True Range

The indicator known as average true range (ATR) can be used to develop a complete trading system or be used for entry or exit signals as part of a strategy. Professionals have used this volatility indicator for decades to improve their trading results. Find out how to use it and why you should give it a try.

What Is ATR?

The average true range is a volatility indicator. Volatility measures the strength of the price action and is often overlooked for clues on market direction. A better known volatility indicator is Bollinger Bands. In “Bollinger on Bollinger Bands” (2002), John Bollinger writes, “high volatility begets low, and low volatility begets high.” Figure 1, below, focuses solely on volatility, omitting price, so we can see that volatility follows a clear cycle.

How close together the upper and lower Bollinger Bands are at any given time illustrates the degree of volatility the price is experiencing. We can see the lines start out fairly far apart on the left side of the graph and converge as they approach the middle of the chart. After nearly touching each other, they separate again, showing a period of high volatility followed by a period of low volatility.

Bollinger Bands are well known and can tell us a great deal about what is likely to happen in the future. Knowing a stock is likely to experience increased volatility after moving within a narrow range makes that stock worth putting on a trading watch list. When the breakout occurs, the stock is likely to experience a sharp move. For example, when Hansen Natural Corporation, which has since changed its name to Monster Beverage Corporation (MNST), broke out of the low volatility range in the middle of the chart (shown above), it nearly doubled in price over the next four months.

The ATR is another way of looking at volatility. In Figure 2, we see the same cyclical behavior in ATR (shown in the bottom section of the chart) as we saw with Bollinger Bands. Periods of low volatility, defined by low values of the ATR, are followed by large price moves.

Trading With ATR

The question traders face is how to profit from the volatility cycle. While the ATR doesn’t tell us in which direction the breakout will occur, it can be added to the closing price, and the trader can buy whenever the next day’s price trades above that value. This idea is shown in Figure 3. Trading signals occur relatively infrequently, but usually spot significant breakout points. The logic behind these signals is that, whenever price closes more than an ATR above the most recent close, a change in volatility has occurred. Taking a long position is betting that the stock will follow through in the upward direction.

ATR Exit Sign

Traders may choose to exit these trades by generating signals based on subtracting the value of the ATR from the close. The same logic applies to this rule – whenever price closes more than one ATR below the most recent close, a significant change in the nature of the market has occurred. Closing a long position becomes a safe bet, because the stock is likely to enter a trading range or reverse direction at this point.

The use of the ATR is most commonly used as an exit method that can be applied no matter how the entry decision is made. One popular technique is known as the chandelier exit and was developed by Chuck LeBeau. The chandelier exit places a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade.

The value of this trailing stop is that it rapidly moves upward in response to the market action. LeBeau chose the chandelier name because “just as a chandelier hangs down from the ceiling of a room, the chandelier exit hangs down from the high point or the ceiling of our trade.”

The ATR Advantage

ATRs are, in some ways, superior to using a fixed percentage because they change based on the characteristics of the stock being traded, recognizing that volatility varies across issues and market conditions. As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader’s desire to protect profits with the necessity of allowing the stock to move within its normal range.

ATR breakout systems can be used by strategies of any time frame. They are especially useful as day trading strategies. Using a 15-minute time frame, day traders add and subtract the ATR from the closing price of the first 15-minute bar. This provides entry points for the day, with stops being placed to close the trade with a loss if prices return to the close of that first bar of the day. Any time frame, such as five minutes or 10 minutes, can be used. This technique may use a 10-period ATR, for example, which includes data from the previous day. Another variation is to use multiple ATRs, which can vary from a fractional amount, such as one-half, to as many as three. (Beyond that, there are too few trades to make the system profitable.) In his 1990 book, “Day Trading With Short-Term Price Patterns and Opening Range Breakout,” Toby Crabel demonstrated that this technique works on a variety of commodities and financial futures.

Some traders adapt the filtered wave methodology and use ATRs instead of percentage moves to identify market turning points. Under this approach, when prices move three ATRs from the lowest close, a new up wave starts. A new down wave begins whenever price moves three ATRs below the highest close since the beginning of the up wave.

The Bottom Line

The possibilities for this versatile tool are limitless, as are the profit opportunities for the creative trader. It is also a useful indicator for long-term investors to monitor because they should expect times of increased volatility whenever the value of the ATR has remained relatively stable for extended periods of time. They would then be ready for what could be a turbulent market ride, helping them avoid panicking in declines or getting carried way with irrational exuberance if the market breaks higher.

A Logical Method of Stop Placement

Trading is a game of probability. This means every trader will be wrong sometimes. When a trade does go wrong, there are only two options: to accept the loss and liquidate your position, or go down with the ship.

This is why using stop orders is so important. Many traders take profits quickly, but hold on to losing trades; it’s simply human nature. We take profits because it feels good and we try to hide from the discomfort of defeat. A properly placed stop order takes care of this problem by acting as insurance against losing too much. In order to work properly, a stop must answer one question: At what price is your opinion wrong?

In this article, we’ll explore several approaches to determining stop placement in forex trading that will help you swallow your pride and keep your portfolio afloat.

Key Takeaways

  • In order to use stops to your advantage, you must know what kind of trader you are and be aware of your weaknesses and strengths.
  • Every trader is different and, as a result, stop placement is not a one-size-fits-all endeavor. The key is to find the technique that fits your trading style.

Hard Stop

One of the simplest stops is the hard stop, in which you simply place a stop a certain number of pips from your entry price. However, in many cases, having a hard stop in a dynamic market doesn’t make much sense. Why would you place the same 20-pip stop in both a quiet market and a volatile one? Similarly, why would you risk the same 80 pips in both calm and volatile market conditions?

To illustrate this point, let’s compare placing a stop to buying insurance. The insurance you pay is a result of the risk you incur, whether it pertains to a car, home, life, etc. As a result, an overweight 60-year-old smoker with high cholesterol pays more for life insurance than a 30-year-old non-smoker with normal cholesterol levels because his risks (age, weight, smoking, cholesterol) make death a more likely possibility.

ATR % Stop Method

The ATR % stop method can be used by any type of trader because the width of the stop is determined by the percentage of average true range (ATR). ATR is a measure of volatility over a specified period of time. The most common length is 14, which is also a common length for oscillators, such as the relative strength index (RSI) and stochastics. A higher ATR indicates a more volatile market, while a lower ATR indicates a less volatile market. By using a certain percentage of ATR, you ensure your stop is dynamic and changes appropriately with market conditions.

For example, for the first four months of 2006, the GBP/USD average daily range was around 110 pips to 140 pips (Figure 1). A day trader may want to use a 10% ATR stop, meaning that the stop is placed 10% x ATR pips from the entry price. In this instance, the stop would be anywhere from 11 pips to 14 pips from your entry price. A swing trader might use 50% or 100% of ATR as a stop. In May and June of 2006, daily ATR was anywhere from 150 pips to 180 pips. As such, the day trader with the 10% stop would have stops from entry of 15 pips to 18 pips, while the swing trader with 50% stops would have stops of 75 pips to 90 pips from entry.

Figure 1 – Source: FXTrek Intellichart

It only makes sense that a trader account for the volatility with wider stops. How many times have you been stopped out in a volatile market, only to see the market reverse? Getting stopped out is part of trading. It will happen, but there is nothing worse than getting stopped out by random noise, only to see the market move in the direction that you had originally predicted. (Further Reading on ATR: Enter Profitable Territory With Average True Range)

Multiple Day High/Low

The multiple day high/low method is best suited for swing traders and position traders. It is simple and enforces patience but can also present the trader with too much risk. For a long position, a stop would be placed at a pre-determined day’s low. A popular parameter is two days. In this instance, a stop would be placed at the two-day low (or just below it). If we assume that a trader was long during the uptrend shown in Figure 2, the individual would likely exit the position at the circled candle because this was the first bar to break below its two-day low. As this example suggests, this method works well for trend traders as a trailing stop.

Figure 2 – Source: FXTrek Intellichart

This method may cause a trader to incur too much risk when they make a trade after a day that exhibits a large range. This outcome is shown in Figure 3 below.

Figure 3 – Source: FXTrek Intellichart

A trader who enters a position near the top of the large candle may have chosen a bad entry but, more importantly, that trader may not want to use the two-day low as a stop-loss strategy because (as seen in Figure 3) the risk can be significant.

The best risk management is a good entry. In any case, it is best to avoid the multiple day high/low stop when entering a position just after a day with a large range. Longer term traders may want to use weeks or even months as their parameters for stop placement. A two-month low stop is an enormous stop, but it makes sense for the position trader who makes just a few trades per year.

If volatility (risk) is low, you do not need to pay as much for insurance. The same is true for stops—the amount of insurance you will need from your stop will vary with the overall risk in the market.

Closes Above/Below Price Levels

Another useful method is setting stops on closes above or below specific price levels. There is no actual stop placed in the trading software; the trade is manually closed out after it closes above/below the specific level. The price levels used for the stop are often round numbers that end in 00 or 50. As in the multiple day high/low method, this technique requires patience because the trade can only be closed at the end of the day.

When you set your stops on closes above or below certain price levels, there is no chance of being whipsawed out of the market by stop hunters. The drawback here is that you can’t quantify the exact risk and there is the chance the market will break out below/above your price level, leaving you with a big loss. To combat the chances of this happening, you probably do not want to use this kind of stop ahead of a big news announcement. You should also avoid this method when trading very volatile pairs such as GBP/JPY. For example, on Dec. 14, 2005, GBP/JPY opened at 212.36 and then fell all the way to 206.91 before closing at 208.10 (Figure 4). A trader with a stop on a close below 210.00 could have lost a good deal of money.

​Figure 4 – Source: FXTrek Intellichart

Indicator Stop

The indicator stop is a logical trailing stop method and can be used on any time frame. The idea is to make the market show you a sign of weakness (or strength, if short) before you get out. The main benefit of this stop is patience. You will not get shaken out of a trade because you have a trigger that takes you out of the market. Much like the other techniques described above, the drawback is risk. There is always a chance the market will plummet during the period that it is crossing below your stop trigger.

Over the long term, however, this method of exit makes more sense than trying to pick a top to exit your long or a bottom to exit your short. How many times have you exited a trade because RSI crossed below 70, only to see the uptrend continue while RSI oscillated around 70? In Figure 5, we used the RSI to illustrate this method on a GBP/USD hourly chart, but many other indicators can be used. The best indicators to use for a stop trigger are indexed indicators such as RSI, stochastics, rate of change, or the commodity channel index.

​Figure 5 – Source: FXTrek Intellichart

The Bottom Line

With trading, you’re always playing a game of probability, which means every trader will be wrong sometimes. It’s important for all traders to understand their own trading style, limitations, biases, and tendencies, so they can use stops effectively.

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