Risk control starts with measurement. Average true range tells you how far a market typically moves in one bar, which tells you where a stop can sit without being hit by ordinary noise, which tells you how many contracts you can hold for the amount you are willing to lose.
None of this makes a trade more likely to work. It decides how much a wrong trade costs, which is the one part of trading you control.
07.1Average true range
J. Welles Wilder introduced average true range in 1978. The true range of a bar is the largest of three distances: high minus low, the high minus the previous close, and the previous close minus the low. ATR is a smoothed average of true range, usually over 14 bars. It measures movement, not direction.
TR = max(high - low, |high - prevClose|, |low - prevClose|)
ATR = Wilder average of TR over n bars // n = 14 by default07.2ATR stops
An ATR stop sits a multiple of ATR away from the entry, for example two times the current ATR. When the market gets more volatile the stop widens; when it calms, the stop tightens. Because the dollar risk per contract changes with ATR, a rule that uses ATR stops should also size positions from the stop distance.
07.3Risk to reward ratio
The risk to reward ratio compares the distance to your stop with the distance to your target. A stop 8 points away and a target 16 points away is 1 to 2. The ratio alone says nothing about a strategy; a far target that is rarely reached is not better than a near one that often is. It is a planning tool for each trade.
ratio = (entry - stop) : (target - entry)
= 8 pts : 16 pts → 1 : 207.4Trading and risk management
Write your limits before the session: the most you will lose in a day, the most per trade, the number of losing trades after which you stop, and the hours you trade. These are the same controls a well-built automated strategy has in code, and they work the same way for a person.
07.5Maximum drawdown
Maximum drawdown is the largest fall from a peak in account value to a later low, before a new peak is made. It is measured from the high point, so it captures the worst stretch an account went through. When reading any track record or backtest, ask for it, and ask whether you could have kept trading through it.
drawdown(t) = (equity(t) - peak_so_far) / peak_so_far
max drawdown = the most negative drawdown(t)Where it usually goes wrong
- Using the same contract count on quiet and wild days.
- Moving a stop further away once the trade is losing.
- Setting a daily loss limit and then overriding it.