Setting Stops Using Average True Range

Setting stops on portfolio positions is often a mixed blessing.  Often, a stop is activated and money is left on the table as the stock continues to rise. One approach is to incorporate volatility and the longer-term trend in determining the stop level or trailing stop threshold. 

The following stop-setting strategy can help an investor stay with the stock’s main trend for as long as possible.  This is an objective-based approach, rather than an approach prone to subjective opinion, enabling the investor to remain honest with himself and his capital.

We are utilizing ATR as a basis of setting stops.  ATR is “Average True Range,” and is calculated based on a stock’s volatility, incorporating recent highs vs. recent lows in a stock’s price.  In the chart below of Apple, the ATR varies approximately from a high of $38 to a low of $10. A simple, objective rule to follow is to use 2x the ATR. There is nothing scientific or “secret sauce” for using 2X other than avoiding daily volatility whipsaws. 

Assuming a buy point of $250 in September 2010 (first blue vertical line), the ATR at that point was $16.  $16 x 2 = $32 stop range, or a stop of $218.  As APPL continues its uptrend, the stop is adjusted at a point where the stock bases, near $325 a share.  At this point, the stop is set just under $300 per share.  This is a simple, mathematical approach that will help the investor avoid arguing with himself about where to set stops.

Similarly, this objective approach can be set with a trailing stop.  Use the same 2X ATR to set the trailing stop and simply let it ride.

We find that using weekly charts and their resulting ATR values are most useful is holding positions as long as possible to maximize gains during an uptrend.  Using ATR as a stop-setting mechanism is a sure way to avoid the trap of guessing when to get out of a position.

As for taking profits (and losses) a prudent strategy is to set such ATR-based stops, but also take random profits (or losses) now and then. An investor can, for example, use the ATR stop strategy on 70% of his portfolio, but apply a concerted profit or loss-taking strategy on the balance of the portfolio.  Markets trend, yet they can also be volatile and easily take away the capital gains that an investor has achieved.

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