DailyFX Tips & Picks: A simple indicator that makes stop losses more effective

STRUGGLING with your stop loss? Try out the Average True Range (ATR) indicator next time you trade. The ATR is a simple tool that shows the average range of a typical trading day. If the ATR shows 83, this means that the distance between the high and low of the day is, on average, 83 pips. And 83 pips also happens to be the current range of sterling-dollar. This means that, if you enter the market today at a random price, and place a 83 pip stop loss, there is a decent likelihood that the position will still be live 24 hours later.

TIGHT STOP LOSSES
Many people will use very tight stop loss distances, as small as 10 pips. Most of the time, they will get stopped out, and this is not strange given that the market, on average, moves 83 pips. There is a 87 per cent likelihood that the price will reach the stop loss, as 73 pips over 83 pips equals 87 per cent.

But the ATR can also be used as a profit target. If the market has rallied by 70 pips from the morning low, we can’t really expect to gain much more than 13 pips given the ATR. This means that we risk 70 pips for a gain of 13 pips. This gives us an inverse risk reward ratio which, as covered in last week’s column, is not good. Instead, it would be better to allow the price to decline to a reasonable level and then go long, while placing a stop of 83 pips.

Alejandro Zambrano is a currency analyst at DailyFX. He leads DailyFX’s Premium Educational Seminars – http://bit.ly/PremiumEDU

Azambrano@dailyfx.com

Twitter: @AlexFX009