There are several strategies to manage the risk that may surprise you. Setting up a risk management strategy that incorporates the Average True Range (ATR) when sizing positions can be one example.
Using the ATR for position sizing will yield a volatility-adjusted stop loss level based on a multiple of the ATR. You need to adjust your position size to ensure that your maximum loss never exceeds your set limit to size your trade. We have a complete guide on Inveslo.com that you can see here. It is recommended to have an ATR multiple of 2-3, but it varies from market to market.
By incorporating ATR into your position sizing process, you can protect yourself against losses while taking volatility into consideration. Therefore, ATR can be used for almost any security, and it will automatically adjust itself when sizing your position.
Since ATR measures the average difference between opening and closing prices, it is essentially a measure of a security's volatility. In combination with position sizing, you have a very basic but efficient risk management system that can assist you in determining the number of shares to purchase based on the maximum amount of capital you are willing to lose.
Suggested read: Forex Risk Management
The art of position sizing is not easy to master. Suppose you are lucky enough to string together a series of successful trades. In that case, the worst thing that can happen to you is that all those trades can be wiped out by one trade, which suddenly goes horribly wrong. It usually happens when you invest in highly volatile instruments because they are more likely to experience large swings.
To avoid all of this hassle, you can use ATR during the position sizing phase of your trade. Based on the market's current volatility, the ATR uses a Simple Moving Average to determine how large of a position is appropriate to avoid losing more money than you are prepared to take on.
Before we jump on the ATR application, let's see how it is calculated.
Since the ATR is based on Moving Averages, you will need to specify a period over which you want to calculate the ATR. Generally, most traders use a period between 10 and 20 trading sessions. If you use the daily time frame, it is worth knowing that 10 trading days represent two weeks, whereas 20 trading days represent roughly one month. For most situations, the default value of 14 is a nice middle-ground value and should be fine for most situations. No matter what period you choose, just make sure you do not stray from your original plan.
The ATR is calculated by averaging the True Ranges (TRs) of the last n periods.
The True Range is the greatest of the following three calculations. Make sure to take absolute values since the direction of price movement is irrelevant:
Subtract the current low from the current high
Subtract the previous close from the current low
Subtract the previous close from the current high
On any specific pair, the higher the ATR reading, the greater the volatility currently considered and the wider the stop should be. A tight stop on a particularly volatile currency pair is more likely to be executed. You can also place smaller stops during periods of less volatility. In this way, traders can avoid making unnecessarily large stops. In most cases, traders using ATR will keep their initial stop away from their open price by at least 1X of the ATR value.
As soon as you have the ATR, you need to determine the maximum loss you are willing to incur on the trade and the nX of the ATR value at which you would like the stop-loss to be placed (ideally a multiple of 2-3). The last thing you will have to do is divide the maximum amount of capital you are willing to risk by the nX of the ATR value to determine how many shares you can purchase.
Put all into an example
Suppose you have $12,000 to invest, and you are willing to risk a loss of 3% or $360 on a trade in EUR/USD. Assumed the EUR/USD has an ask price of 1.01234 with an ATR of 0.0012 or 12 pips. An ATR multiple of 2 lets us know that the maximum amount of pip we are willing to put at risk on a single trade is 0.0024 pips. Once you have this number, you can finish your position sizing. Simply divide $360 by $0.0024, and you will know how many EUR/USD to buy.
360 / 0.0024 = 150,000 units or 1.5 lots
In this case, the answer is 1.5 lots.
Based on the information above, you need to place your stop-loss 0.0024 pips below your entry price or at 1.00994 to limit your risk to $360 if the trade goes against your prediction.
You now have a risk management strategy in place, even though it is very basic. Afterwards, you should monitor your position and its ATR periodically to ensure you have a complete understanding of the trade. It is common for the ATR to change quite a bit, requiring an adjustment to your stop-loss. You should continue monitoring your trade and making adjustments as needed.