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Section 7: SL Orders based on Volatility Indicators (ATR)

This is another way at looking objectively at SL placement. Setting the stop loss order based on volatility indicators has an important advantage: as the volatility increases, the SL level is set further away from the entry price, and as the volatility decreases, the SL level is set closer to market action. This is logical since when the volatility is higher than usual the market could move against our trade a little more than usual and the trade still could had a chance to work out. Also when the market volatility is lower than usual, we don't need that much room to know if our trade is going to work. 

The best indicator used for this purposes is the ATR. It is built into MetaTrader and almost all charting and broking platforms as commonly used and widely accepted

ATR stands for Average True Range 

This is a volatility based indicator; it measures the tendency of any currency pair to fluctuate. 

The ATR is defined by its creator Welles Wilder to be the greatest of the following: 
  • The distance from the last period high to today’s low
  • The distance from the second last period close to the last high
  • The distance from the second last period high to the last low
Applying the average of the greatest will give us the ATR for a predetermined amount of periods. 

Setting the stop levels based on the ATR: 

1. Get the reading of the ATR 

2. Multiply it by a constant. We recommend using a constant of 2 or 3. For instance, if the ATR reading is at .0012 or 12 pips, 12 x 2 = 24 or 12 x 3 = 36

3. The stop loss level will be set at 24 (if used we used a 12 x 2) or 36 (12 x 3) away from our entry point. Let us take a look at some charts. 

1

[Chart 1] 

As we can see, there are periods in which it is better to have a stop loss order further away from market action, like the third trade. The ATR reading is .0016 (16 pips) if we used a constant of 2, the SL would be placed 32 pips away from the entry level. 

At our first trade things are different; volatility is lower than the last and in this case we could need a smaller SL in order to see if this trade is going to work because the market is likely to fluctuate less than usual. At this point the ATR reading is .0006 and the stop level should be placed 12 pips away from our entry point. 

If the market goes 12 pips against us, then it is more likely to keep going against us since it already went 2 times the average volatility against us. 

This method factors in periods when the market is more volatile due to external aspects as well as at peak trading times and at important events

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