If you ask any professional trader about what is the most important aspect of their trading strategy, it is more than likely that they would mention about how money management plays a vital role in their overall trading performance.
There are several money management strategies like setting a fixed stop-loss in terms of an absolute numbers of pips, having a fixed risk tolerance level based on a fixed dollar amount, a certain percentage of the account balance. However, regardless which strategy you want to apply, you always need to figure out where to set your stop-loss first.
Most beginner traders make the mistake of setting a fixed stop-loss regarding the number of pips per trade. While doing so, they ignore vital technical analysis clues like fixing the stop-loss beyond significant support and resistance levels and end up focusing on how many pips they want to risk per trade.
By contrast, advanced traders know that risking the number of pips is irrelevant as you can increase or decrease your position size and always risk a certain amount of capital per trade. Hence, they adjust their money management on each and every trade by taking account of the actual volatility level.
For example, some Forex pairs like the EUR/GBP are less volatile than the GBP/JPY. If you set a 50 pips stop-loss for GBP/JPY, most of your trades would likely end up losing, only because you are setting a very narrow margin of error. On the other hand, if you set a 50 pips stop-loss for the EUR/GBP, you might be too lenient, because the volatility of this pair is so low.
Today, we are going to show you a way to use the Average True Range (ATR) indicator to find out the optimum stop-loss for any given trade. Not only that, but we will also discuss how you can further optimize the Average True Range stop-loss and make your money management strategy more effective.
Before we get into the practical application of Average True Range in money management, keep in mind that when you see that the Average True Range value is going up, it does not indicate if the price is going up or down. Instead, the indicator mainly signals that traders are pushing the price much higher or lower, which basically means an increase in price volatility.
Figure 1: Average True Range Value Indicates Level of Volatility
Most software packages, like the MetaTrader 4, calculates the Average True Range value based on the last 14 periods. Here, the Average True Range indicator value, as shown in figure 1, represents the average volatility of the asset for the given number of periods.
So, on a daily chart, it would calculate the ATR of last 14 days, and on an hourly chart, it would calculate the ATR based on the last 14 hours, and so on.
In figure 1, the ATR value for GBPUSD was 0.0097, and if you used a multiplier of 2, your stop-loss for any trade taken on the daily timeframe that day should have been 0.0194 or 194 pips.
Figure 2: Microsoft and the Average True Range - Chart by Tradingview
You can use the Average True Range value or a multiplier of the value as a fixed stop-loss. The rationale behind using the Average True Range value instead of a predefined fixed pips value like 50 pips or 100 pips stop-loss is that with the Average True Range value, you are setting a dynamic risk for the trade by acknowledging the actual volatility in the market.
Most professional traders end up using either 1.5 or 2 times the ATR value as their stop-loss. The logic is that if the asset price has reversed more than the ATR value, the prevailing trend is probably over and it is a good time to close your position and accept a loss instead of holding on to a losing trade.
While using Average True Range to set a dynamic stop-loss solves the problem of having a pre-defined fixed stop-loss, it still doesn’t help us to risk a fixed amount of capital on each and every trade.
To do so, you need to turn to a method called Percentage Risk Model (PRM), which was popularized by trading coach Van Tharp. The basic idea behind PRM is that regardless the actual pip size of your stop-loss, you will always risk a fixed dollar amount on every trade.
With PRM, if you always want to risk 2% of your capital on every trade, you just need to find the dollar amount, then divide that figure with your ATR stop-loss.
For example, let’s say you have $10,000 equity in your Forex brokerage account and you want to risk 2% of your equity on a trade based on 2x daily ATR value. Let’s assume the daily ATR is 0.0100, which means with a multiplier of 2; your stop-loss should be 200 pips. As 2% of $10,000 is $200, all you need to do is divide $200 by your 200 pips stop-loss, and you will find your optimum position size for the trade, which would be $1 per pip! Hence, if you are trading with a mini account, your position size should be one mini lot.
When you combine the power of PRM and ATR, you get a very powerful money management strategy that compensates for the actual volatility in the market, but also help you risk a certain percentage of your trading capital on each trade, regardless which Forex pair you are trading.
Moreover, as we discussed, Average True Range allows you to trade any Forex pair with the same technical strategy, as you would always risk the same percentage of your equity regardless if the pair is moving 100 pips per day or only 10 pips.
If you can successfully master the art of integrating Average True Range in your money management strategy, it would certainly give you an uncanny edge over other market participants.