How To Trade

41. How to Use the Average True Range (ATR) To Set Stops

In our last lesson we looked at determining how much you are willing to risk on any one trade as the first step in developing a successful money management strategy. Now that we have established this, in today's lesson we are going to look at some of the different ways that you can then set your stop, which fit within this initial criteria.

As we learned in last lesson, risking more than 2% of total trading capital on any one trade is a major reason for the high failure rate of most traders. Does this mean that when setting a stop we should simply figure out how many points away from our entry represents 2% of our account balance and set the stop there? Well, traders could obviously do this and to be honest it would probably be a lot better than most of the other money management strategies I have seen, but there better ways.

Although many traders will look at other things in conjunction, having an idea of the historical volatility of the instrument you are trading is always a good idea when thinking about your stop loss level. If for instance you are trading a $100 stock which moves $5 vs. a $100 stock that moves $1 a day on average, then this is going to tell you something about where you should place your stop. As it is probably already clear here, all else being equal, if you put a stop $5 away on both stocks, you are going to be much more likely to be stopped out on the stock which moves on average $5 a day than you are with the stock that moves on average $1 a day.

While I have seen successful traders who get to know a list of the things they are trading well enough to have a good idea of what their average daily ranges are, many traders will instead use an indicator which was designed to give an overview of this, which is known as the Average True Range (ATR)

Developed by J. Welles Wilder the ATR is designed to give traders a feel for what the historical volatility is for an instrument, or very simply how much it moves. Financial instruments that exhibit high volatility move a lot, and traders can there fore make or lose a lot of money in a short period of time. Conversely, financial instruments with low volatility move a relatively small amount so it takes longer to make or lose money in them all else being equal.

As with many of the other indicators we have studied in previous lessons, Wilder uses a moving average to smooth out the True Range numbers. When plotted on a graph it looks as follows:

What you are basically seeing here is a representation of the daily movement of the EUR/USD. As you can see when the candles are longer (which represents large trading ranges and volatility) the ATR moves up and when the candles are smaller (representing smaller trading ranges and volatility) it moves down.

So with this in mind, the most basic way that traders use the ATR in setting their stops is to place their stop a set number of ATR's away from their entry price so they have less of a chance of being knocked out of the market by "market noise".

42. How to Up Your Chances for Profit When Setting Stops

In our last lesson we learned about the Average True Range (ATR) and how traders use this to get an idea of the volatility in the market so they can incorporate this into their stop levels. In today's lesson we are going to add an additional factor that most traders consider important when setting stops, support and resistance.

As we have learned in previous lessons many traders will use technical analysis to determine where support and resistance is in the market, and look for trading opportunities based on what that chart analysis tells them. In addition to using technical analysis to find support and resistance levels in which trades can be entered, many successful traders also use this method of analysis to determine where their stops should be placed.

One of the most popular methods which we have touched on in previous lessons where many traders use support and resistance in their trading is when trading ranges in the market. Many traders favor ranges, as they provide traders with the ability to enter trades with tight stop losses and much larger potential returns. The reasoning here is that traders can enter a trade just below resistance or just above support in the range, place their stop just outside that level and then their profit target at the other end of the range. Generally the distance between the stop level is much shorter than the distance between the other end of the range, providing traders with a great opportunity for a relatively low risk and potentially high reward trade.

43. How to Reduce the Chances of Being Stopped Out on a Trade

In our last lesson we looked at how many successful traders incorporate support and resistance into their trading strategies. In today's lesson we are going to expand on this concept by looking at how many traders look for multiple support or resistance levels when placing trades as well as how many chart patterns incorporate this concept already, providing traders with areas in which they can place their stops.

As we learned about in our last lesson, when setting a stop many traders will find a level of support if they are buying to enter the trade or resistance when they are selling to enter the trade and place there stop outside of this level. When entering trades many successful traders will also look for trades which have few if any levels of support/resistance in the direction they are trading, but several levels of support/resistance in the direction in which they are placing their stop.

As we have also learned in previous lessons, one of the key reason's why traders favor or recognize certain chart patterns is because they often times signal what is next to come in the market. What is often overlooked however about almost all of the most popular chart patterns, but perhaps just as important, is their ability to point out potential places where you want to place your protective stop loss.

As you can see from the below chart the head and shoulders pattern is a perfect example of this. By entering the trade on a break of the neckline and placing the stop just above the right shoulder of the pattern traders ensure that there are at minimum two resistance levels in between their entry price and their stop level if not more.

44. How Successful Traders Use Indicators to Place Stops

In our last lesson we learned how many successful traders look for entry opportunities which allow them to set their stop so that there are multiple support or resistance points between their entry point and stop level, and few if any support or resistance points between their entry price and their target. In today's lesson we are going to look at another factor that many traders use when deciding where to place their stops, the use of technical indicators.

As you hopefully remember from watching my previous lessons we have already covered two indicators and gone over specific strategies on how they can be used to set stops which are the Average True Range and the Parabolic SAR. While these indicators were designed specifically to help traders gauge where to place their stops, many of the other indicators which we have looked at using to pick trade entry points can also be used to decide when to exit a trade.

With this in mind the question then becomes, with all the options available how do you choose which indicator if any to look at when deciding when to exit a trade. Which indicator if any you choose to include in your money management strategy for setting stops is going to depend largely on the type of strategy that you are trading. As a general rule however if you use an indicator to signal for example a buy entry on a trade most traders will keep an eye on that same indicator and take into account when that same indicator signals to exit a trade.

As an example of this, lets say that your analysis of the ADX shows that the chart of x is about to start a nice trend and you decide to place a trade on that analysis. Using the knowledge you have gleaned from our lessons on stops so far you also pick a level for your stop which has some nice protection and is close enough that it fits within your two percent loss limit. During this trade however if the ADX which is the indicator you used primarily to enter the trade begins to signal that the trend is weakening and the market is about to range, should you remain in that trade? The answer to that question is going to depend on the strategy and what other things are going on in the market at the time, but I would say at minimum most successful traders would take this into account when deciding whether or not to continue with the position, regardless of whether their stop had been hit or not.

Lastly on this point there is one indicator that so many traders watch that many traders will at least keep an eye on what happens with this indicator and that is the 50 and the 200 day moving average. These indicators are in general thought to be representative of the overall trend in the market and a break above or below these levels and/or a crossing of the 50 day moving average above/below the 200 day moving average is normally seen as significant for a market and as such many traders will take this into account and place their stops accordingly.

As you probably have noticed when thinking about placing stops using indicators, as you don't know where price is going to be when your indicator signals for a trade exit, you do not have a hard stop in the market, are in the very bad position of not being protected in your trade. This is why, as we have talked about many times in our other lessons, that if this method for setting stops is used it should always be used in conjunction with another method which allows you to set a hard stop and stays within the 2% loss limit rule we have established.

This concept of the stop being a sort of "moving target" is a nice lead in to our next concept and lesson where we are going to be talking about what is known as a trailing stop.

45. Stop Your Mind From Causing You to Take Profits Too Soon


In yesterday's lesson we looked at how many traders use technical indicators as an additional factor they consider when deciding when to exit a trade. In today's lesson we are going to begin to move into the next phase of our series on money management, with a look at how traders go about taking profits once a position moves in their favo,r and some of the difficulties that are associated with this.

Before getting into the details of what a trailing stop is and how many traders use them, it is first important to understand the psychology behind taking profits. Develop

From the last several lessons you should not have a good understanding of some of the psychological difficulties people have in taking losses, and some of the different money management strategies that can be put into place to help overcome these difficulties that are the downfall of so many traders.

What may come as a surprise to many of you is that just as many traders have problems letting their profits run as they do in cutting their losses. To help illustrate this I am going to give a quote from one of my favorite books on money management strategies Trade Your Way to Financial Freedom by Dr. Van K. Tharp. When explaining this concept in his book he gives the example below:

When given a chance for "1. a sure $9000 gain or 2. a 95% chance of a $10,000 gain plus a 5% chance of no gain at all....which would you choose?"

A study which was done on this showed that 80% of the population chose the sure thing even though the second opportunity represents a $500 larger gain on average.

Similar to the way that human's are raised in a way that does not allow them to accept losses our environment also teaches us to seize opportunities quickly, or "that a bird in the hand is worth two in the bush", a rule that goes against the second half of the most important rule of trading:

"Cut Your Losses and Let Your Profits Run"

With this in mind we can now move into the next phase of our series of money management with a look at some of the different ways that traders go about managing their position once it begins to move in their favor starting with a look at trailing stops.

Once a position has begun to move in a traders favor, many traders will implement a trailing stop which is basically a strategy for moving the stop they have implemented on their position up when they are long or down when they are short to lesson the loss or increase the amount of profit they will take should the market reverse and begin to move in the opposite direction of their position.

46. How To Use Trailing Stops

As we spoke about briefly in yesterday's lesson, once a position has begun to move in a traders favor many successful trader's will manage that position through the use of what is known as a trailing stop. The simplest type of trailing stop is what is known as a fixed trailing stop which simply moves along behind a position as that position begins to move in the traders favor. The beauty of the fixed trailing stop, is that while it will move up behind a long position or down behind a short position as the position moves in the traders favor, if at any time the position begins to move against the trader, the stop does not move, essentially locking in a large portion of the gains the trader has made up to that point.

Let's say for example that you had been following the trend in the EUR/USD chart below which started back in August and were looking for an opportunity to get into a trade. Based on your analysis you decided that if the market broke out above the little resistance point that I have highlighted on the chart below and the ADX was in a good position that you were going to enter long at 1.4360 to try and ride the trend. To manage the trade if it moved in your favor you placed a 100 Point trailing stop on the position at 1.4260. Now in this example if the market moved against you from the start 100 points your stop at 1.4260 would not have moved and you would have been executed on that order when the market touched 1.4260. As you can see from the chart below however, in this example the market did not pull back but went higher. As our stop is a 100 point trailing stop once the market moved up from 1.4360 the stop is going to continue to move up remaining 100 points behind the current price. If the market moves down however the stop does not move. So in this example once the market stoped moving higher at 1.4752 so did our stop and since the market pulled back 100 points from that level we were stopped out in this example at 1.4652.

Most trading platforms will allow you to set a fixed trailing stop on the platform so you do not have to manually manage the order.

As we have touched on briefly in previous lessons, indicators can also be used as trailing stops. One of the more popular indicators which was designed specifically for this purpose is the Parabolic SAR which we covered several lessons ago and you should review if you have not done so already.

As we discussed in our lesson on the Average True Range (ATR), this and other methods for measuring volatility in the market are often used to set hard stops by traders when entering the market so they do not get stopped out by market noise. In addition to using the ATR as a hard stop, this and other volatility based indicators can also be used as a trailing stop, moving your hard stop along behind the position a set number of ATR's for instance as it moves in your favor. As with a hard stop this protects your position from market noise, while allowing you to look in profits should the market begin to move against you.

Many if not all of the other indicators could also be used as trailing stops with the Moving Average probably one of the more popular here as well.

Aside from fixed and indicator based trailing stops another strategy that many traders implement is a fixed percentage of profits trailing stop. Using this method a trader will set his hard stop his profit target, and then once the market hits his profit target will then begin trailing a stop which could be any combination of the methods above. This method gives the trader a greater chance that the trade will hit his profit target but provides less protection should the market reverse and begin to move against him.

47. Why Position Sizing is So Important in Trading

So far in the lessons leading up to this one we have covered some of the different methods traders use to pick their entry points, as well as some of the different methods which traders use to set their exit points. In this lesson we are going to look at the factor which ties all of the above together and allows a trader the greatest control over their returns: Position Sizing.

While position sizing is one of the Key components of successful trading, like many of the other things we have covered, it is often overlooked as an unimportant aspect of trading. What successful traders know however is that once the psychology of trading is mastered and a trader has developed a sound strategy for picking their entry and exit points, it is the method they use to determine the size of the positions they trade that is the final factor which will lead to their success or failure.

To help illustrate this lets say that three traders are each given $10,000 and the same EUR/USD Mini Forex strategy to trade which has a win rate of 60% (makes a profit on 6 out of 10 trades) and makes an average profit on winning trades over the long term of 100 Points. On the losing side, this same system has a lose rate of 40% (takes a loss on 4 out of 10 trades) and takes an average loss on those trades of 90 points.

So here we have a trading strategy that has more winning trades on average than it does losing trades, as well as a strategy that when it does lose it loses less than what it does when it wins. I think most traders including myself would take that system any day of the week.

So we give these traders each this system and tell them to come back to us after 10 trades and show their results. As the system is the same for all traders, when they bring us back the trading results of their systems the entry points and exit points for each trade is going to be the same, leaving them only the position size as the factor that they can tweak.

48. Why Fixed Position Sizing Is Not the Best Way to Trade

In yesterday's lesson we introduced another important yet often overlooked aspect of trading and money management which is position sizing. In today's lesson we are going to begin to look at some of the strategies that many successful traders use to determine their position sizes.

As we discussed briefly in the last lesson many traders make the mistake of choosing an arbitrary number such as 1 contract or 100 shares of stock to trade when they first enter the market. In addition to the fact that this does not consider the amount of capital a trader has at his disposal, it also does not take into account the fact that the Dollar value as well as the volatility characteristics of one contract or 100 shares of stock is going to very greatly. Like a poker player who bets the same amount on every hand, this also does not allow a trader the flexibility to trade bigger on trades with a higher probability of success and smaller on trades with a lower probability of success.

As you can see from the picture below, a trader trading 100 shares of a $20 stock which fluctuates 5% a day and a second position of 100 shares of a $30 stock which fluctuates 1% a day does not present the risk/reward picture that many traders would expect it would. In this example the smaller position actually has a greater potential risk and reward because of the greater volatility of the first stock in the example.

The next level of sophistication up from the above, is trading a standard trade size such as 1 contract or 100 shares of stock for every fixed amount of money. As Dr. Van K. Tharp points out however in his book Trade Your Way to Financial Freedom, there are several distinct disadvantages to using this method which are:

1. Not all Investments are Alike (100 shares of a $10 stock which moves 5% a day is not going to be the same as trading 100 Shares of a $10 stock that moves 1% a day)
2. It does not allow you to increase your exposure rapidly with small amounts of money
3. You will always take a position even when the risk is too high.

As you can hopefully see from the above information, while the fixed position size per dollar amount is better than simply picking a number of thin air, there are many disadvantages to this method. In tomorrow's lesson we will begin to look at some different ways of overcoming these disadvantages starting with a discussion of the martingale and anti martingale position sizing strategies so we hope to see you in that lesson.

49. Trading The Martingale and Anti Martingale Strategies

In our last lesson we looked at how most traders pick a standard amount to trade per certain amount of equity in their account and how this probably isn't the best way to maximize profits and minimize losses of a potential strategy. In today's lesson we are going to look at the two categories that most position sizing strategies fall into which are known as martingale strategies and anti martingale strategies.

A position sizing strategy which incorporates the martingale technique is basically any strategy which increases the trade size as a trade moves against the trader or after a losing trade. On the flip side a position sizing strategy which incorporates the anti martingale technique is basically any strategy which increases the trade size as the trade moves in the traders favor or after a winning trade.

The most basic martingale strategy is one in which the trader trades a set position size at the beginning of his trading strategy and then double's the size of his trades after each unprofitable trade, returning back to the original position size only after a profitable trade. Using this strategy no matter how large the string of losing trades a trader faces, on the next winning trade they will make up all their losses plus a profit equal to the profit on their original trade size.

As an example lets say that a trader is using a strategy on the full size EUR/USD Forex contract that takes profits and losses both at the 200 point level (I like using the EUR/USD Forex contract because it has a fixed point value of $1 per contract for mini forex contracts and $10 per contract for full sized contracts but the example is the same for any instrument)

The trader starts with $100,000 in his account and decides that his starting position size will be 3 contracts (300,000) and that he will use the basic martingale strategy to place his trades. Using the below 10 trades here is how it would work.

As you can see from the example although the trader was down significantly going into the 10th trade, as the 10th trade was profitable he made up all the his losses plus a brought the account profitable by the equity high of the account plus original profit target of $6000.

At first glance the above method can seem very sound and people often point to their perception that the chances of having a winning trade increase after a string of loosing trades. Mathematically however the large majority of strategies work like flipping a coin, in that the chances of having a profitable trade on the next trade is completely independent of how many profitable or unprofitable trades one has leading up to that trade. As when flipping a coin no matter how many times you flip heads the chances of flipping tails on the next flip of the coin are still 50/50.

The second problem with this method is that it requires an unlimited amount of money to ensure success. Looking at our trade example again but replacing the last trade with another loosing trade instead of a winner, you can see that the trader is now in a position where, at the normal $1000 per contract margin level required, he does not have enough money in his account to put up the necessary margin which is required to initiate the next 48 contract position

So while the pure martingale strategy and variations of it can produce successful results for extended periods of time, as I hope the above shows, odds are that it will eventually end up in blowing ones account completely.

With this in mind the large majority of successful traders that I have seen follow anti martingale strategies which increase size when trades are profitable, never when unprofitable, and these are the methods which I will be covering starting in tomorrow's lesson.

50. How to Set Trade Position Size for Maximum Profits

we talked about the martingale and anti martingale methods of trading which are the two categories which position sizing methodologies fall into. In today's lesson we are going to talk about one of the most basic anti martingale strategies, which is discussed in Dr. Van K. Tharp's book Trade Your Way to Financial Freedom, the Percent Risk Model.

The first step in determining your position size using this method is to decide how much you are going to risk on each trade in terms of a percentage of your trading capital. As we have discussed in our previous lessons on setting stop losses, studies have proven that over the long term traders who risk more than 2% of their capital on any one trade normally are not successful over the long term. Another factor to consider here when setting this percentage are things such as the win rate (how many winning trades) your system is expected to have versus the number of losing trades as well as other components which we will discuss in future lessons.

Once this loss in percentage terms has been determined, setting your stop then becomes a function of knowing how large a position can be traded while still being below your maximum risk level.

As an example lets say you have $100,000 in trading capital and you have determined from analyzing your strategy that 2% or $2000 (2%*$100,000) of your trading capital is an appropriate amount to risk per trade. When analyzing the Crude Oil Futures market you spot an opportunity to sell crude at $90 a barrel at which point you feel there is a good chance it will trade down to at least $88 a barrel. You have also spotted a strong resistance point at just below $91 a barrel and feel that 91 is a good level to place your stop and also gives you a reward to risk ratio of 2 to 1.

From trading crude oil you know that a 1 cent or 1 point move in the market equals $10 per contract. So analyzing further to determine your position size you would multiply $10 times the number of points your stop is away from your entry price (in this case 100) and you would come up with $1000 in risk per contract. Lastly you divide the total dollar amount you are willing to risk by your total risk per contract ($2000 total risk/$1000 risk per contract) to get the number of contracts which you can place on this trade (in this case 2 contracts)

As Dr. Van K. Tharp Points out in his book Trade Your Way to Financial Freedom, the advantages of this style of position sizing are that it allows both large and small accounts to grow steadily and that it equalizes the performance in the portfolio by the actual risk. As he also points out the disadvantages of this system are that it will require you to reject some trades because they are too risky (ie you will not have enough money in your account to trade the minimum contract size while staying under your maximum risk level) and that there is no way to know for sure what the actual amount you are risking will be because of slippage which can result in dramatic differences in performance when trading larger positions or using tight stops.