Managing your risk exposure according to volatility

In order to define volatility, we're going to use the Average True Range here.

The Average True Range (ATR) is the moving average of a given period's absolute range. It is generally calculated over 14 periods.

One can define the risk level according to the currency pair's historical volatility over the unit of time with which we will be working on.

First of all, let's calculate the risk that we'll tolerate per trade of 1% of a $100,000 account:

$100,000 * .01 = $1,000 per trade

Next, let's take the ATR of the unit of time that we're interested in. Let's say that we've got an ATR at 25 points per 60 minutes (our unit of trading) and the value of a pip is $2.

The calculation of our stop is as follows:

Stop > or = (3*25) = 75 points

In monetary terms, this is = $2 * 75 points = $150 risked per contract.

Now, let's use the size of the stop per contract to determine the size of a position.

If we're willing to risk $1,000 per trade, we still need to find out the number of contracts we can take on. In order to do this, we divide $1,000/our risk per contract = $1,000/$150 = 6.66 contracts.

As this result isn't a round number, we'll round down to the nearest whole number, so for this example we would there trade up to 6 contracts.

Disadvantages:

Stops are rather large.

Psychological pressure due to the distance of the stop.

Advantages:

Certainty of being well positioned whenever the markets sets out on a trend.

According to Van K. Tharp, this money management method allows you to make money even with 100% random entries. (see Trade Your Way to financial freedom on Index page below)