To The Moon

In the article When Should You Stop Loss or Profit?, we discussed the importance of "stop-loss" and "never take-profit". Today, we will talk about how to operate a stop loss and trailing take profit order.

The trailing take profit means you don’t sell stock when the price continues to rise, but you do when the upward trend reverses.

Some retail investors prefer to cut losses by setting a fixed percentage, such as a 5% or 7% decline. But this fixed percentage does not take into account that different stocks have different volatility. Some stocks with low volatility may indeed need a stop loss when it is down 5%; but for stocks with high volatility, there may often be a 5% drop in a day. Therefore, we should consider the different volatility of individual stocks.

The ATR indicator can take the volatility of individual stocks into account.

ATR (Average True Range), as the name suggests, is the calculation of the true volatility range of each stock on a daily basis.

The equation for calculating ATR is a bit more complicated, but we don't need to do the math because almost all trading platforms provide ATR indicators. All you need to do is click on this button and choose the 14-day period for ATR, as shown below.

The orange line in the chart is the stock's daily ATR. For example, $Pfizer(PFE)$ current ATR is $1.51$. It means that for the last 14 days, Pfizer's stock price fluctuated within the range of 1.51$.

• How to use ATR to stop loss: The stock price on the day you bought it - 1.5~2xATR= your stop-loss point.

Take Pfizer for example, today's ATR is 1.51, 1.5x ATR is 2.27$. We suppose you buy Pfizer at the current price of $47.44,the stop-loss price is: 47.44-2.27 = 45.17. When the stock price is higher than 45.17, you don’t need to stop losses; but when the stock price falls to/below45.17,you shouldfirmlycut your losses.

• How to take profit with ATR: The price of recent high point-1.5~2x ATR=your take-profit point.

Again using Pfizer as an example, let's say you bought Pfizer some time ago and it has been going up since then. You have been following the uptrend and have not taken your profit. Then Pfizer reaches its recent high of $61.71.The ATR for that day was $2.41 and 1.5x ATR is $3.62. If Pfizer fell from the high to 61.71-2.41=58.09, you would take profit and close the position.

Later data also proved that it was very wise to use a 1.5x ATR stop losses. Pfizer made a new high on Dec. 20 and fell to58.09 (the take profit point you set) on Dec. 29. And the later trend has been down(the pink line), indicating that the take-profit choice was proper at that time. Of course, Pfizer is just an example of ATR, which will not necessarily apply to all cases.

In short, there is no statistical advantage to using 1.5-2x ATR indicator for stop-loss or trailing take profit. However, it takes into account the volatility of individual stocks relative to fixed percentage. In addition, and most importantly, it can give us a practical and actionable trading discipline. Adhering to such stop-loss and take-profit rules over time can be very beneficial.

However, it is also important to note that this fixed indicator approach is applicable to the general environment. We should be aware that the stock market and the world situation are very volatile right now. With the possibility of a Black Swan event happening at any time, and we should not rely too much on the numbers.

Have you understood how to use ATR?

What's your stop-loss or take-profit method?

Share your opinions with me~