You may have heard professional traders talk about numerous strategies for managing risk that go right over your head. While it might be hard for a beginner to know where to start, the good news is that anyone can set-up a basic risk management strategy for their trades by incorporating the Average True Range (ATR) when position sizing.
ATR can be used in position sizing by calculating a multiple of the ATR to come up with a volatility-adjusted stop loss level. In order to size your trade, you then need to adjust your position size so that your maximal loss never will exceed your set limit. A good ATR multiple is often somewhere around 2-3 but varies with market and strategy.
Once you incorporate ATR in your position sizing process, you have a method of protecting yourself against a loss which manages to take volatility into account. This means that ATR can be used for nearly any security and it will automatically adjust itself during your position sizing.
Can I Benefit From Using ATR When Position Sizing?
Remember that ATR is essentially the measure of a security’s true volatility since it measures the average difference between the opening and closing prices. Once you couple it with position sizing, you have a very basic but efficient risk management system that can guide you on the number of shares to purchase depending on the maximum amount of capital you are willing to lose on a single trade.
Position sizing is an art which can be quite difficult to get right. The worst thing that can happen is that you string together a series of successful trades only to have them all wiped out by one trade which goes terribly wrong. This would usually happen due to you investing in a highly volatile security as it has a much higher chance of going on a large downswing.
However, the good news is that you can use ATR when you are in the position sizing phase of your trade to avoid all of this hassle. The ATR is based on the volatility of a security and utilizes the Simple Moving Average to determine how large your position should be relative to the maximum amount of loss you are willing to stomach.
What all of this means is that you can use ATR when position sizing any commodity and it will automatically adjust your position. For example, Gold is a lot more volatile than the S&P 500 (on average). As such, using ATR in your position sizing will cause you to invest less money in gold provided that you are willing to lose the same amount of money on both the securities.
How to Calculate ATR when Position Sizing
Before we dive into the math, remember that you do not need to know how to calculate ATR. There are numerous screeners out there who will calculate the ATR for you so that you can commence position sizing. If you are still interested in how ATR works, read on to first figure out how to calculate the ATR of a chart and then how to use it in position sizing.
Since the ATR is based on Moving Averages, you need to set the period for the average. Most traders use a value between 10 and 20 (10 trading days represent 2 weeks while 20 trading days represent a month, roughly). The default value of 14 is a nice middle-ground and should be fine for most situations. Whatever you select, just make sure you stay consistent.
In order to calculate the ATR, you first need to calculate the True Range (TR) of each of the last n periods and then calculate their average.
True Range is the greatest of the following 3 calculations (Remember that you need to take absolute values since the direction of the price movement is irrelevant):
- Subtract current low from the current high
- Deduct the previous close from the current high
- Deduct the previous close from the current low
Use ATR in Position Sizing
Once you have the ATR, you must decide the maximum amount of capital you are willing to lose on the trade along with the ATR multiple that you are placing the stop-loss at (A good ATR multiple is often around 2-3). For example, if your ATR is $5, then you can lose up to 10$ a share with a 2 ATR multiple before the stop-loss kicks in.
Once you have all of the aforementioned figures, the last calculation you need to do is to divide the maximum amount of capital you can risk by the value of the ATR multiple to arrive at the number of shares you can purchase.
Example of ATR in Position Sizing
Suppose you have $150,000 to invest and you are willing to risk a loss of $5000 on a trade in Apple. The stock, at the time of writing, trades at $192.74 and has an ATR of $4.57. An ATR multiple of 2 lets us know that the maximum amount of money we are willing to lose on a single share is $9.14. Once you have this number, you can finish your position sizing. Simply divide $5000 by $9.14 and you will know how many shares to purchase of Apple.
In this case, the answer is 547.
Based on the information above, you need to place your stop-loss $9.14 below your purchase price (stop-loss will be at $183.6 in this scenario). The total amount of money you will be putting into Apple will be $105,428.8 (shares to purchase * price per share).
Now, you have a risk management strategy in place, albeit a very basic one. After this, it is best to monitor your position and its ATR at intervals so as to make sure you have a complete handle on the trade. Often times, the ATR may change by quite a bit, requiring your stop-loss to be altered as well. Just continue to monitor your trade and make adjustments if necessary.
Trading Without a Stop Loss
Stop losses is a prerequisite for effective trading. Without it, you run the risk of incurring huge losses in the event of a black swan event, or heavy market turmoil. However, there are strategies where you could consider to remove the stop loss and use other means of risk management.
Mean reversion strategies are one group of strategies that often do not benefit from having a stop loss, and the reason lies in the logic of mean reverting strategies. In mean reversion, essentially, we are catching falling knives. We go against the short term trend, because we know that the probabilities of the market reverting are high, since the market has overextended itself. What we also know, is that the more market moves against us, the higher the odds of an imminent turnaround.
Keeping this in mind, it would be somewhat irrational to cut your losses at a certain stop loss level. Since the market now has moved even further against you, the odds of it turning around are even higher than when you entered the trade. That is why having a stop loss in mean reverting strategies ay not work as well as with other types of strategies.
Using ATR in position sizing can be incredibly beneficial for people who want to have a dedicated system which limits their loss of capital. This is a system which is great for beginners but can be used by advanced traders too since it works so incredibly well. Just remember that in order to make sure a strategy like this works properly, you need to implement it consistently and avoid getting greedy with the parameters at all costs.
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