Last Updated on 17/09/2024 by Ndanileka

As we all know, trading involves many components, and one of the most crucial elements we quickly realize in our trading journey is the importance of a stop-loss.

I like to think of a stop-loss as the point where my trading system tells me that my initial entry setup’s probabilities and risk-reward are no longer valid. Signaling, that continuing with the trade from this point may carry additional risk, prompting the question: *Do you want to continue or exit?*

So, how do we set this stop-loss? How do we determine the right level to exit the market? Is there a “perfect” stop-loss level? The truth is a simple NO. There isn’t a holy grail for stop-losses and that’s just the unpredictable nature of the market.

However, we can still use tools to contextualize the fluctuations around our entry levels. One such tool is the Average True Range (ATR), which helps us establish stop levels in line with market volatility, where the stop level is based on the volatility of the assets rather than using a fixed percentage, giving a more dynamic approach.

## How to use the ATR for Stop-loss levels

There are countless ways to apply an ATR stop to a trading system. For this tutorial, I’ll walk through the two most common approaches, which can be seen as building blocks for further refinement.

The ATR stop consists of two key parts:

**The ATR Value**– A measure of the typical volatility in price.**The Multiplier**– A value used to multiply the ATR based on your desired risk level.

The general formula for calculating stop-loss is:

- For a long position:
**Stop-loss level = (Close Price or Entry****Price**) – (ATR Value * Multiplier) - For a short position:

**Stop-loss level = (Close Price or Entry Price ) + (ATR Value * Multiplier)**

**Example:**

Now, suppose we have a stock with an ATR of 4, a previous close of 125, and your entry trigger for a long position is at 127, here’s how to calculate stoploss based on the fundamental methods.

**Method 1****Stop-Loss Based on Close Price**

This approach uses the previous close as a reference point for setting the stop-loss:

= Stop-loss level

= Close Price – (ATR * Multiplier)

= 125 – (4 * 1)

= 121

**Key Consideration:**

Since the stop is based on the** close price** and not your entry, this could result in needing a higher risk-reward ratio to account for the gap between the close price and entry. For example, if you entered at 127, your stop at 121 might now be further from your entry than you would prefer, requiring larger price movements for you to have a “good” risk-to-reward ratio.

**Method 2****Stop-Loss Based on Entry Price**

The stop-loss is calculated relative to your entry price:

= Stop-loss level

= Entry Price – (ATR * Multiplier)

= 127 – (4 * 1)

= 123

**Key Consideration:**

Since the ATR value is based on the previous **close price**, using the **entry price **to set the stop-loss might result in a smaller stop-loss. For example, if the ATR was calculated from a close price of 125 and the market has since moved up to 127, your stop-loss level at **123** is closer to the entry price than a stop-loss based on the close price (121). In a volatile market, this could mean the stop is tighter than expected based on average fluctuations, potentially leading to an earlier exit from the trade.

#### ATR Multiplier

The ATR Multiplier is a factor used to adjust the Average True Range (ATR) by multiplying the ATR by a specific value. A higher multiplier sets a wider stop-loss, while a lower multiplier creates a tighter stop-loss. The multiplier allows you to customize the stop-loss distance to better match the volatility of the asset and your risk management strategy.

Continuing with the **Method 2** example, a stop loss level with an ATR Multiplier of 2 would be calculated as follows:

=Stoploss Level

=Entry Price – (ATR * Multiplier)

=127 – (4 * 2)

=119

#### Spreadsheet

For intermediate traders, the spreadsheet should be easy to follow. However, for clarity, here is a description of each label:

**Stock Code**: Enter the ticker symbol of the stock you’re trading.

**ATR Period**: The number of days used to calculate the Average True Range (ATR). **Account Balance:** The total amount of money in your trading account, used to determine position size and risk.**Risk Per Trade%**: The percentage of your account balance that you’re willing to risk on a single trade.

**Multiplier**: The factor applied to the ATR value to adjust the stop-loss level. A higher multiplier widens the stop-loss, while a smaller multiplier tightens it.

**Entry Price**: The price at which you plan to enter the trade. This value is essential for calculating your stop-loss and position size.

**Trade Direction**: Specifies whether you’re taking a long or short position, which determines the direction of the stop-loss calculation.

**ATR**: The Average True Range, a measure of market volatility. It shows the average price movement over a specified period.

**ATR Multiple**: This is the ATR value multiplied by the selected multiplier. It defines the distance between your entry price and stop-loss based on volatility.

**Risk Amount**: The monetary value you’re willing to risk on the trade, calculated from your account balance and risk percentage.

**Position Size**: The total monetary value of the position you’re taking, determined by your risk amount and stop-loss levels.

**No of Shares**: The number of shares you should purchase (or sell) based on your position size and entry price.

**Stop Loss**: The price level at which you will exit the trade to limit your losses, based on the ATR and multiplier.

**Stop Loss %**: The percentage change in price required to reach your stop-loss level. It reflects the distance between your entry price and the stop-loss.

**1R**: Represents your risk in monetary terms. It’s the value of 1 unit of risk, helping you track potential reward or loss.

**1R%**: The percentage of your account balance that equals 1 unit of risk.

**Soft Target (1R)**: The price level at which your potential profit matches your risk (1R), serving as a guide for where to consider exiting the trade.

Happy Trading

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