Trading Basics
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In this article we will explain:
- How to develop a very basic Trading Plan for every holding.
- What Average True Range means.
- How to measure risk on a stock by stock basis.
- How to Position Size holdings depending on risk.
- How to use ATR to set stop losses.
- What a Renko chart is and how to use it.
A QUICK RENKO LESSON
Here is the Renko chart of the ASX 200.
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- Renko charts are not time based charts - the usual time scale can look odd with uneven spacing.
- These charts are based on the size of share price movements. If the price doesn’t move for a year, nothing ‘prints’ on the chart.
- You can set them up however you like but the way most Renko charts are set up is to print a new “Brick” (Renga in Japanese) every time the share price moves more than 1 x ATR (Average True Range - see below).
- You can use Daily or Weekly Renko charts which plot bricks using either the Daily or Weekly ATR.
- The charts print a new brick every time the price moves one ATR from the last brick.
- On our Renko charts, a yellow brick means the price has fallen one ATR from the last brick. And a blue brick is if the share price has risen one ATR from the last brick.
- If it's a Daily Chart a brick means it's move 1 x the Daily ATR. And so on for Weekly.
WHAT IS ATR - AVERAGE TRUE RANGE
The daily ATR (Average True Range) is calculated using the range a share price moves from top to bottom each day (the range) and averaging the last 14 days of ranges. It is a volatility measure. So volatile stocks have high ATRs (big range every day) and boring stocks have low ATRs. You can find an ATR on the STOCK BOX and in the ALL ORDS SPREADSHEET (you don’t need to, the chart is doing it for you). A weekly ATR looks at the range each week over the last 14 weeks. These charts use daily ATRs.
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Sidenote – You’ll see on the STOCK BOX and in the ALL ORDS SPREADSHEET that each stock also has its Daily and Weekly ATRs expressed as a percentage of the share price. This allows you to compare the volatility of individual stocks.
EXAMPLES
This is the Telstra STOCK BOX. The ATRs are highlighted. So Telstra (over the last 14 days) has moved on average 6.3c from top to bottom every day. It has moved 12.9c from top to bottom each week. (Interestingly the weekly ATR is almost always around 2 x the Daily ATR). And, on that basis, you’ll see Telstra moves in a range of 1.6% a day and 3.3% a week.
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Let's look at a more volatile stock – Pilbara Minerals (PLS). As you can see, PLS is moving 15.7c a day and 34.9c a week which is 4.4% a day and 9.8% a week.
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- Comparing the two you can see that PLS is twice as volatile as TLS. It has been moving 4.4% a day versus 1.6% for PLS, and 9.8% a week compared to 3.3% for PLS. That tells you PLS is almost 3x more volatile than TLS. 3x as risky if you like. Good information before you buy a stock.
- Using the ATR as a percentage of the share price (shown on the STOCK BOX and in the ALL ORDS SPREADSHEET) you can work out how risky stocks are compared to each other. PLS is three times as risky as TLS (TLS is one of the least volatile stocks in the market by the way).
- Traders use this measure to assess their risk and to do what’s called “Position Sizing”. They put less money into risky stocks and in so doing limit their exposure to risk.
- Taking this a bit further. Position Sizing is done by working out how much money you are prepared to lose on one trade. The very common way to do this is to use what is called the 2% Rule. This is a rule which dictates that you cannot lose more than 2% of your capital on one trade and you set a stop loss to control that.
EXAMPLE OF HOW TO CALCULATE THE SIZE OF A TRADE
- If you have $100,000 in your Super you set a rule that you cannot lose more than $2,000 a trade (2% of $100,000). That’s pretty standard.
- You now decide what your stop loss is. Using a rolling 2 x ATR would be a conservative stop loss (3x for traders). This means you are prepared to allow the stock to drop 2 x ATR below its daily ATR but if it drops more than that you’ll sell it. So for PLS above, if the stock drops more than 31.4c (2 x the daily ATR of 15.7c) from the highest price its hit since you bought it, you’ll sell it.
- Now you calculate on that basis how much stock you can buy.
- If you can lose 31.4c and your maximum tolerated loss is $2,000 the number of shares you buy calculates itself. Its $2,000 divided by 31.4c.
- So you can buy a maximum of 6,369 shares in PLS.
- The PLS share price is 335c. So you can buy a maximum of $21,337 shares of PLS (6,3679 x $3.35).
- So you put in an order to buy say 6,350 shares (round down) at 335c. Cost $21,272.5.
- And you can allow it to drop 2x its daily ATR (2 x 15.7c) below you stop yourself out.
- So if you get it right and monitor the stop loss accurately, you could lose a maximum of 31.4c x 6,350 shares ($1,994).
Now let's do the same thing for Telstra. Which is less volatile.
- The Daily ATR is 6.3c.
- You set a 2x ATR stop loss.
- That means you can lose 12.6c per share on the trade.
- If your maximum loss is $2,000 then you can buy 15,873 shares of TLS (2000 divided by 12.6c).
- In which case, with a share price of 394c you can buy $62,539 worth of TLS (394c x 15,873 shares).
- That's almost three times as much capital committed to a trade in TLS compared to PLS...because PLS is three times as volatile - it's more risky, so you limit your exposure.
And there you have it. In a less risky stock you can commit a lot more capital. Position sizing is bigger in less volatile stocks. Smaller in risky stocks.
The benefits of doing this calculation:
- You can only lose a preset amount of capital per trade/position. In this case $2,000. 2% of total capital.
- The risk/volatility of the stock has controlled how many shares you can buy. Smaller positions for riskier stocks.
- You now also have a trading plan – “I’ll sell if it drops 2x ATR and I’ll roll up the stop loss as the price goes up”.
The only pain is that monitoring an ATR stop loss is a manual job and quite time-consuming. You constantly have to change your stop loss depending on how high the share price goes (you ratchet it up, a stop loss is never adjusted lower).
Side note - If you are a bigger risk taker and you use a wider stop loss (say 3 or 4 ATR) as some traders do, the number of shares you can buy drops because you are taking more risk.
And that's trading basics. Combining ATR, Stop Losses and Position Sizing.
BACK TO RENKO CHARTS.
Now you can see the value of Renko charts. If you are using a 2 x ATR stop loss they alert you when a stock has dropped 2 x ATR because each 'Brick' is one ATR. They also clean up the noise and provide 'clear' pivot points.
- Pilbara Minerals (PLS) - Not selling this pone in this trend, not until you get two yellow bricks.
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- Telstra - Has just plotted two yellow bricks, which means its dropped 2 x ATR - stop loss triggered. Come back later.
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- This is OZR - The Resources sector ETF, using a Renko chart. It's dropped 3x ATR. We're out.
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