Just to recap, volatility refers to the amount that a market can potentially move over a given time. If you already know how much a particular market can tend to move, you’ll have a better idea of where to set your stop loss to avoid being impetuously taken out of a trade on random instabilities of price action.
Think about it this way. If you are taking a trade on USD JPY and over the last couple of weeks, it has moved around 80 pips a day, setting your stop loss 20 pips away from your opening position runs a huge risk of getting stopped out way early on a slight intraday move that goes against you.
By having a good grasp on market volatility, you can get a better handle on where to set your stops to give your trades a little bit of wiggle room to move.
Using Bollinger Bands to Measure Volatility and Set Your Stop-Loss
We’ve already spoken about the Bollinger Bands as a measure of volatility. They are a great technical indicator to help you determine a range wherein price might fluctuate.
Bollinger Bands can give you a great guideline on where to set your stop-loss, especially if price action lends itself to range trading.
Simply set your stop loss beyond the bands, whether it is above them or below them.
Using Average True Range (ATR) to Measure Volatility and Set Your Stop-Loss
You can also use the Average True Range (ATR) to find volatility and a good place to set your stop loss. The ATR requires you to enter the period or number of candlesticks that the ATR references to calculate the average range. For example, if you are looking at an hourly chart, and you use the number fifty as an input, then the ATR indicator will tabulate the average range for that market over the past fifty hours.
The idea then is to place your stop loss either above or below the average true range that you have specified to give your trade enough wiggle room to account for recent market volatility.
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