Calculate Average Trailing Stops Using ATR

[Harpreet]

A trailing stop is a dynamic stop-loss order that moves with the price of a security. It helps protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in a favorable direction, while closing the trade if the price changes direction by a specified amount. An Average Trailing Stop (ATS) calculation involves using an average metric, such as the average true range (ATR), to determine the stop distance. Here’s how to calculate an ATR-based trailing stop:
Steps to Calculate Average Trailing Stops Using ATR

1. Calculate the True Range (TR) for each period: The True Range is the greatest of the following:
   • Current high minus the current low
     
   • Absolute value of the current high minus the previous close
     
   • Absolute value of the current low minus the previous close
     
   Formula:
   
   TR=max⁡(High−Low,∣High−Previous Close∣,∣Low−Previous Close∣)\text{TR} = \max(\text{High} - \text{Low}, |\text{High} - \text{Previous Close}|, |\text{Low} - \text{Previous Close}|)
   TR=max(High−Low,∣High−Previous Close∣,∣Low−Previous Close∣)
   
2. Calculate the Average True Range (ATR): The ATR is a moving average of the True Range values over a specified period (e.g., 14 days).
   Formula:
   
   ATR=∑i=1nTRin\text{ATR} = \frac{\sum_{i=1}^{n} \text{TR}_i}{n}
   ATR=n∑i=1nTRi
   where nnn is the number of periods.
   
3. Determine the Trailing Stop Distance: Decide on a multiplier for the ATR (commonly 1.5 or 2 times the ATR). The trailing stop distance will be this multiplier times the ATR.
   Formula:
   
   Trailing Stop Distance=ATR×Multiplier\text{Trailing Stop Distance} = \text{ATR} \times \text{Multiplier}
   Trailing Stop Distance=ATR×Multiplier
   
4. Set the Trailing Stop: For a long position, subtract the trailing stop distance from the highest high since the entry:
   
   Trailing Stop=Highest High Since Entry−Trailing Stop Distance\text{Trailing Stop} = \text{Highest High Since Entry} - \text{Trailing Stop Distance}
   Trailing Stop=Highest High Since Entry−Trailing Stop Distance
   For a short position, add the trailing stop distance to the lowest low since the entry:
   
   Trailing Stop=Lowest Low Since Entry+Trailing Stop Distance\text{Trailing Stop} = \text{Lowest Low Since Entry} + \text{Trailing Stop Distance}
   Trailing Stop=Lowest Low Since Entry+Trailing Stop Distance
   

Example Calculation

1. Calculate True Range (TR): Assume you have the following prices:
   • Current high: $105
     
   • Current low: $100
     
   • Previous close: $102
     
   TR=max⁡(105−100,∣105−102∣,∣100−102∣)=max⁡(5,3,2)=5\text{TR} = \max(105 - 100, |105 - 102|, |100 - 102|) = \max(5, 3, 2) = 5
   TR=max(105−100,∣105−102∣,∣100−102∣)=max(5,3,2)=5
   
2. Calculate Average True Range (ATR): Suppose the TR values over the last 14 periods are as follows: 5, 4, 6, 3, 5, 4, 5, 6, 7, 4, 5, 6, 5, 4.
   
   ATR=5+4+6+3+5+4+5+6+7+4+5+6+5+414=6914≈4.93\text{ATR} = \frac{5 + 4 + 6 + 3 + 5 + 4 + 5 + 6 + 7 + 4 + 5 + 6 + 5 + 4}{14} = \frac{69}{14} \approx 4.93
   ATR=145+4+6+3+5+4+5+6+7+4+5+6+5+4=1469≈4.93
   
3. Determine the Trailing Stop Distance: Using a multiplier of 2:
   
   Trailing Stop Distance=4.93×2=9.86\text{Trailing Stop Distance} = 4.93 \times 2 = 9.86
   Trailing Stop Distance=4.93×2=9.86
   
4. Set the Trailing Stop: If the highest high since entry was $110:
   
   Trailing Stop=110−9.86=100.14\text{Trailing Stop} = 110 - 9.86 = 100.14
   Trailing Stop=110−9.86=100.14
   

Thus, for a long position, the trailing stop would be set at $100.14. This level will adjust as the highest high since entry changes, always maintaining a distance of 9.86 units (based on the ATR) below the highest high.
Conclusion
Trailing stops based on ATR provide a dynamic way to protect gains by adjusting to market volatility. This method allows traders to set stops that are neither too tight (avoiding premature exits) nor too loose (protecting profits effectively). The use of ATR helps account for changes in market conditions, ensuring that the trailing stop adapts to current volatility levels.