Risk & Money Management · Intermediate · 5 min
Volatility-based position sizing (ATR)
You can calculate true range, explain what the average true range measures and use it to set stop distances and position sizes.
Calm or wild?
A stop 1.00 below the entry can be generous for a calm share and far too tight for a volatile one. In the first case it gives the trade plenty of room. In the second, ordinary daily movement hits it within hours.
A fixed stop distance ignores how much a market actually moves. This lesson shows a common way to measure that movement and to build it into your stops and position sizes.
How far it typically moves
The true range of a bar is its full span, including any gap from the previous close. It is the largest of three values:
- the current high minus the current low,
- the current high minus the previous close,
- the previous close minus the current low.
The extra two cases catch gaps. If a share closes at 50 and opens the next day at 52, a simple high-low range would miss the jump.
The average true range, or ATR, is the average of the true range over a number of bars, typically 14. J. Welles Wilder introduced it in his 1978 book on trading systems, originally with commodities in mind, which often gap. ATR measures volatility only. It says nothing about direction.
The chart shows the same fictional share in two phases. In the first six candles, the true range is about 0.70 per day. In the last six, it is about 2.40, more than three times as much.
Traders use ATR in two ways:
- Stop distance. Many place the stop a multiple of the ATR away, for example 1.5 or 2 × ATR, so that the stop sits outside the normal daily movement. Ideally, this agrees with a level on the chart, like a swing low.
- Position size. With the stop distance known, the usual formula applies: money at risk ÷ stop distance. When volatility rises, the stop gets wider and the size smaller, so the risk in money stays the same.
The multiple is a choice, not a law, and it should be tested on the market and timeframe you trade.
71 shares or 20
A fictional trader has 10,000, risks 1% per trade and places stops 2 × ATR from the entry.
- Calm phase: ATR 0.70. Stop distance 1.40. Size 100 ÷ 1.40 = 71 shares, rounded down.
- Volatile phase: ATR 2.40. Stop distance 4.80. Size 100 ÷ 4.80 = 20 shares.
In both cases, a loss at the stop costs about 100. Without ATR, a trader using a fixed stop of 1.40 in the volatile phase would have been stopped out by ordinary movement on most days. A trader keeping 71 shares with the wider stop would have risked about 340, more than three times the plan.
Common mistakes
- Reading ATR as a signal. A rising ATR means larger moves, in either direction.
- Keeping the size when ATR rises. A wider stop with the same size raises the risk.
- Using ATR from another timeframe. Daily ATR does not fit a stop on a 5-minute chart.
- Ignoring the chart. An ATR stop that sits just above an obvious low is still in a weak place.
The takeaway
The average true range measures how far a price typically moves. Stops based on it adapt to volatility, and position size keeps the risk fixed.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the candle with the largest true range.
Tap the chart.
Candle 9 runs from 39.20 to 41.80, a true range of 2.60, the largest on the chart.
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2Yesterday closed at 50. Today's high is 51 and low 49.50. What is today's true range?
The largest of: high − low = 1.50, high − previous close = 1.00, previous close − low = 0.50. So 1.50.
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3What does the ATR tell you?
ATR measures volatility only. Wilder designed it to include gaps that a simple high-low range would miss.
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4ATR rises from 0.70 to 2.40. Using a stop of 2 × ATR and the same risk, what happens to the position size?
The stop distance grows from 1.40 to 4.80, so the same money at risk buys about 0.29 times as many shares.
of 4 correct.
Sources
- StockCharts ChartSchool: Average True Range (ATR)
- J. Welles Wilder: New Concepts in Technical Trading Systems (1978, book)