An experienced trader will know how important it is to separate their emotions from trading decisions. This is particularly important when it comes to deciding how much to risk and when to cut losing trades. The purpose of this guide is to teach you how to remove your emotions from position sizing and stop losses using an indicator called Average True Range (ATR). Let’s get started…
● Position sizing and stop losses are key components in profitable trading.
● The ATR can help determine optimal stop loss placement and position sizing.
● Plot the ATR on the BSTE platform using the charting tool.
● Use the ATR to calculate stop loss.
● Use the $ value of the stop loss to calculate position size.
● Use the BTSE order platform to enter a stop loss order.
Stop Losses and Position Sizing
● A stop loss is a predetermined and automatic order to exit a position.
● Your position size is the initial $ value of the trade.
Many traders make the mistake of focusing on their efforts on determining when to enter a trade. The reality is, entry signals are usually not what distinguishes a profitable trader from an unprofitable one.
Imagine a scenario where you are presented with a weighted coin toss game – 70% chance of heads and 30% chance of tails. A correct guess doubles your bet and an incorrect guess loses it all. You have $100,000 and you can bet as many times as you like.
How much should you bet?
If you bet the entire $100,000 on one game, there is a 30% chance that you lose everything in the first game. Conversely, if you bet $1,000 on 100 games you give the 70/30 statistical advantage a chance of materializing in the results. It is no different with trading.
You might have a strategy that is profitable 70% of the time, but incorrect position sizing can blow up your account in one trade. A profitable strategy needs to be traded a large number of times for its statistical advantage to materialize.
One way to do this is to use stop losses to restrict the amount risked per trade to no more than 1% – 2% of your total trading capital. This allows a sample size of 100 to 50 trades for the statistical edge of your trading strategy to materialise. Moreover, when combined with a volatility indicator like ATR, a stop loss can be used to intelligently size positions and avoid being triggered by the average ‘noise’ fluctuations of the market.
How to use the Average True Range (ATR) Indicator
Simply put, the ATR measures volatility.
● The ATR indicator can be used to set stop losses outside the range of typical volatility or ‘noise’.
● This avoids the common error of setting stop losses too close to entry prices and having trades ‘stopped out’ before they can move in the desired direction.
● A stop loss set at 2 x ATR will require the price to move twice the amount of its average noise before the position is automatically closed.
Here’s how to use the ATR indicator:
Step 1: Find a chart on the BTSE platform.
Step 2: Click on the “indicators” tab in the top chat toolbar.
Step 3: Select “Average True Range” from the drop down menu.
Step 4: Record the ATR value for use in stop loss calculation.
Incorporating ATR into Stop Losses and Position Sizing
Now that we’re ready to use the ATR, let’s go ahead and long ETH/USD. As mentioned earlier, it is important not to risk too much of your trading capital on any one trade. For the purposes of this example, let’s assume we only want to risk 2% of our capital.
- With a starting capital of $10,000, 2% amounts to $200.
- Therefore, the $ value of our stop loss must = $200.
Now, let’s assume we want to set our stop loss at 2 x ATR to avoid being stopped out by average noise fluctuations.
- With an ATR of 12.4313, 2 x ATR = 24.8626. Therefore, our stop loss would be set at $24.8626 below our long position entry at $204.15 – i.e at $179.2874
- If triggered, this stop loss would represent a loss of 12.17% on the originally traded value.
- Therefore, to work out our position size we take the $200 (dollar value stop loss) and divide by 0.1217 = $1643.38
In order to comply with our assumed risk management rules of 2% per trade, the position size for this trade must be $1643.38 with a stop loss placed at $179.2874
That would look something like this…
● The ATR is constantly changing. You can use the dynamic value of ATR to create trailing stop losses or update existing stop losses to new volatility considitions.
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