When working with new traders in the FX Power Course, we try to impress on them the importance of using a protective stop in every trade. Identifying and limiting your risk are keys to long term success. However, where we place that protective stop is another matter. The problem is that a 100 pip stop on the EUR/GBP is not the same as using a 100 pip stop on the GBP/JPY.
The volatility of the two pairs is quite different and can also change from week to week. So we need to find a tool that gives us a way to quantify the current market environment in each currency pair to determine our stop level. One such tool is the ATR or Average True Range. A simplified explanation of the ATR is that it measures the range of a session in pips and then determines the average range of a certain number of sessions. For instance, if using a daily chart with a default value of 14, the ATR will measure the average daily range, from high to low of the previous 14 days. This way you are getting a current reading on the volatility of a specific currency pair. The current 14 day ATR for the EUR/GBP is 41 pips while the same 14 day ATR for the GBP/JPY is 239 pips. So we can see why a standard 100 pip stop is not the best way to determine your risk on every trade. Many traders will simply use the ATR for their risk. They would place their stop 41 pips from their entry in a EUR/GBP trade and 239 pips from their entry in a GBP/JPY trade. This is one way to base your risk on the reality of the current market you are trading which can increase your chance of success.
Written by Thomas Long, FX Power Course Instructor for DailyFX.com