An ATR trailing stop is one way to manage a trade at both the time of entry as a stop loss setting and if it evolves into a winning trade by exiting when the price reverses far enough to trigger a trailing stop exit.
This type of trailing stop uses the technical indicator of the Average True Range which is a measure of the magnitude of current price volatility, it is a moving signal and expands as the trading range grows and contracts as the trading range gets smaller.
This process is based on the fact that the ATR is a measurement of the average volatility of the price action in a set time period. This is a mechanical trailing stop and is quantified taking away the psychological pressure of discretionary decision making about where to set an initial stop-loss at entry and where to exit a winning trade based on a trailing stop.
The Average True Range technical reading is calculated with the daily price range change and uses the greatest of three possible readings: ‘high minus the previous close’, ‘previous close minus the low’ or the ‘high minus the low’. For an ATR trailing stop the 21-day period average ATR is commonly used. A multiple of 3 is plotted with the ATR on the chart as a visual trailing stop to use for signaling in most cases.
In the case of a long position the 3 ATR would be trailing below the price on the chart in the case of a short position the 3 ATR would be trailing above the price.
The ATR is a moving indicator and changes with the degree of volatility in price action. It will be wider range in highly volatile charts and tighter in less volatile charts. A 2 ATR trailing stop can be used in extremely volatile markets to lower the risk of the distance to the stop loss or trailing stop.
Using an ATR trailing stop starts at entry, if price gets lower than 3 ATRs away from your entry price you exit for a loss at that technical level. If your trade is a winner then you exit the winning trade when price reverses lower than 3 ATRs.
Using an ATR trailing stop is a type of trend following system that allows your winners to run and cuts your losses short while also giving room for a trade to work out without a premature exit.
The ATR trailing stop is a risk management tool and exit signal used after an entry signal is taken and not a signal to buy.
This is a mechanical way to manage your trade exits.