Markets do not move the same way every day. Sometimes they are calm, sometimes volatile. Volatility-based position sizing adjusts your trade size based on current market conditions, ensuring you take consistent risk regardless of how wild the market is. The most popular tool for this is ATR (Average True Range).
Why Fixed Dollar Stops Fail
Many traders use fixed dollar or fixed percentage stops. The problem: a $2 stop on a stock that normally moves $5 per day is too tight, while a $2 stop on a stock that moves $0.50 per day is way too wide.
The insight: Your stop loss should be based on what the market actually does, not an arbitrary number. ATR tells you what the market "normally" does.
What is ATR (Average True Range)?
ATR measures the average price movement over a period, typically 14 days. It accounts for gaps and gives you a sense of how volatile a stock is.
True Range Calculation
True Range is the greatest of:
- Current High minus Current Low
- Absolute value of Current High minus Previous Close
- Absolute value of Current Low minus Previous Close
ATR is the average of True Range over your chosen period (usually 14 days).
ATR Example
Stock XYZ has a 14-day ATR of $3.50
This means, on average, the stock moves about $3.50 per day.
A stop loss of 1 ATR ($3.50) gives the trade room to breathe within normal movement.
The ATR Position Sizing Formula
Here is the core formula for volatility-based position sizing:
Formula
Position Size = (Account x Risk%) / (ATR x ATR Multiplier)
- Account: Your trading account size
- Risk%: The percentage you want to risk (e.g., 2%)
- ATR: Current 14-period ATR
- ATR Multiplier: How many ATRs for your stop (typically 1-3)
Complete Example
Let us work through a detailed calculation:
Setup
- Account: $50,000
- Risk: 2% = $1,000
- Stock Price: $85
- 14-day ATR: $2.80
- ATR Multiplier: 2 (stop at 2x ATR)
Calculation
- Stop Distance: $2.80 x 2 = $5.60
- Position Size: $1,000 / $5.60 = 178 shares
- Position Value: 178 x $85 = $15,130
- Stop Price: $85 - $5.60 = $79.40
Choosing Your ATR Multiplier
The ATR multiplier determines how much room you give your trades:
- 1x ATR: Tight stop, high chance of being stopped out by noise
- 1.5x ATR: Balance between tightness and room
- 2x ATR: Standard, works well for swing trades
- 2.5-3x ATR: Wide stop, good for trend following
Recommendation: Start with 2x ATR for swing trades. If you are getting stopped out too often in profitable moves, increase to 2.5x. If your losses are too big when wrong, decrease to 1.5x.
ATR Adapts to Market Conditions
The beauty of ATR is automatic adjustment:
Same Stock, Different Volatility
Calm Market (ATR = $2.00):
- Stop: 2 x $2.00 = $4.00
- Position: $1,000 / $4.00 = 250 shares
Volatile Market (ATR = $5.00):
- Stop: 2 x $5.00 = $10.00
- Position: $1,000 / $10.00 = 100 shares
You risk the same $1,000 in both scenarios, but your position size automatically adjusts to volatility.
ATR vs Fixed Stops
Compare the results over different market conditions:
- Fixed $3 stop: Gets stopped out in volatile markets, leaves money on table in calm markets
- ATR-based stop: Adapts to conditions, consistent risk exposure
Implementing ATR Position Sizing
Step-by-Step Process
- Look up the 14-period ATR for your stock (most charting platforms show this)
- Decide your ATR multiplier (start with 2)
- Calculate stop distance (ATR x multiplier)
- Calculate your dollar risk (account x risk percentage)
- Divide dollar risk by stop distance to get shares
- Set your stop loss at entry minus stop distance (for longs)
For Options Traders
ATR can help with options by adjusting strike selection:
- Sell puts 1-2 ATRs below current price
- Use ATR to determine how wide your spreads should be
- Adjust position size based on underlying ATR
Common ATR Mistakes
- Using wrong timeframe: Match ATR period to your trading timeframe. Day traders might use 5-period ATR on hourly charts.
- Ignoring ATR expansion: ATR increases during trends. Be aware that your stop is getting wider.
- Not recalculating: ATR changes daily. Recalculate position size for each new trade.
- Too tight multiplier: Using 1x ATR means 50% chance of being stopped in normal movement.
Advanced: Normalizing Positions Across Stocks
ATR lets you compare apples to apples. A $10 stock with $2 ATR is actually more volatile than a $100 stock with $5 ATR (20% vs 5% volatility).
ATR Percentage
ATR% = ATR / Stock Price
- Stock A: $10 price, $2 ATR = 20% ATR
- Stock B: $100 price, $5 ATR = 5% ATR
Stock A is 4x more volatile despite smaller dollar ATR.
Track Volatility Automatically
Pro Trader Dashboard integrates volatility metrics and helps you size positions appropriately. Stop calculating ATR manually and focus on finding good trades.
Summary
Volatility-based position sizing using ATR is one of the smartest ways to manage risk. It automatically adjusts your position size based on market conditions, ensuring consistent risk exposure whether markets are calm or chaotic. Use 2x ATR as your starting point and adjust based on your trading style and results.
Want to learn more about risk management? Check out position sizing formulas or explore portfolio heat management for managing multiple positions.