Why You Should Use Average True Range to Set Stop Losses

Why You Should Use Average True Range to Set Stop Losses

A trader enters a long position on NVIDIA (NVDA) with a stop loss set at a flat 2% below the entry price. Within twenty minutes, a momentary spike in volatility triggers the stop, kicking the trader out of the position. Moments later, the stock reverses and climbs 5% toward the original target. The trader wasn't wrong about the direction, but they were wrong about the volatility. This post explains how to use the Average True Range (ATR) to ensure your stop losses are placed outside the "noise" of normal price movement.

Most retail traders use arbitrary percentages or fixed dollar amounts to set stops. This is a mistake because it ignores the specific volatility profile of the asset. A 2% move in a stable utility stock like Duke Energy (DUK) is a massive event, whereas a 2% move in a high-growth tech stock is just a Tuesday. The Average True Range (ATR) solves this by measuring the average distance between the high and low of a candle over a specific period—typically 14 days.

How to Implement ATR-Based Stops

Instead of guessing where "pain" begins, use a multiple of the ATR to create a buffer. This method adjusts your risk dynamically based on how much the market is actually moving.

• Identify the ATR Value: Look at your charting software (such as TradingView or Thinkorswim) and add the ATR indicator to your chart. Note the current value.
• Determine Your Multiplier: A common standard is 2x or 3x the ATR. A higher multiplier gives the trade more "room to breathe" but requires a larger initial capital outlay for the same position size.
• Calculate the Exit: If you are going long on Apple (AAPL) at $190 and the 14-day ATR is $3.50, a 2x ATR stop would be placed at $183 ($190 - $7.00).

Using this method prevents you from being "stopped out" by standard intraday volatility. However, be warned: a wider stop means you must reduce your position size to keep your total dollar risk consistent. If you increase your stop distance from 2% to 5% using ATR, you must decrease your number of shares to ensure a single losing trade doesn't devastate your account.

Managing your exit is just as vital as the entry. Once your trade moves in your favor, you may want to transition from a static ATR stop to a trailing stop to lock in profits, allowing the volatility-adjusted buffer to move up with the price action.

Risk Note: ATR is a lagging indicator. It tells you what the volatility has been, not necessarily what it will be. During unexpected news events or earnings reports, volatility can spike instantly, rendering your historical ATR calculation obsolete.