Position Management, Part II: Trailing Stop And Exit Techniques
In “Position Management, Pt. I: Initial Stop Placement,” we analyzed ways to determine how best to place initial protective stops (IPS). The techniques we covered included volatility based stops, using both average true range (ATR) and historical volatility (HV), dollar-based stops, and pattern-based stops.
Here, we will look more closely at true position management techniques–what to do after you’ve entered a position and set your initial protective stop. The techniques that come in to play here–deciding how to use trailing stops and take profits–are critical to controlling risk.
As I mentioned in the previous article, getting in a trade is the easy part. Exiting positions, on the other hand, is probably the biggest dilemma for any trader. Exit too soon, and you may miss out on a substantial move. Stay in too long, and you can give back some or all of your open profits. The methods we’ll outline in the following sections are designed to help you to manage your trades most effectively, in terms of both risk and reward.
Trailing stops
A trailing stop follows your position as it progresses, rising with the market (when you are long) and falling with the market (when you are short). For example, if you bought a stock at 50 and used a two-point trailing stop, you would move your stop order progressively higher, say, from 48, to 49 to 50, and so on, as time passed and the market rallied from 50, to 51 to 52, respectively.
A basic principle is to tighten your trailing stop as the position becomes profitable, locking in a larger percentage of your gains as time passes. There are several methods of doing this; the ones we will look at are based on recent highs and lows, chart patterns and volatility.
Volatility Based To use a volatility based trailing stop, you simply take the volatility formula used to set the IPS (as explained in the first article of the series) and update it daily (or whatever time frame you are trading on). Keep in mind that you should only tighten the stop as time passes.
For example, referring to Figure 1, suppose you were lucky enough to go short1 at the recent minor top in the bond market (a). Also suppose you decided to use 1-1/2 times the two-period ATR as your initial protective stop level (IPS on chart). To trail your stop, you simply update the ATR figure every day. As time passes, the ATR line varies both with and against the direction of the trend. However, we only tighten or “trail” the stop (TS). In other words, we never loosen the stop even though the volatility based method may dictate that the market has the potential to trade there.
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| Figure 1. Dec. 99 T-bonds (USZ9), daily. ATR-based trailing stop. Source: Omega Research.
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Although we have used the ATR in this example, another volatility calculation (i.e., historical volatility) could be used just as easily
Recent highs and lows Recent highs and lows provide a simple but quite often effective method for trailing stops. In Figure 2, we used a three-day high as our trailing stop (placing the stop above the highest high of the most recent three days). The logic in this case is that if a market is truly trending, it should not give back more than a few days’ gains.
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| Figure 2. Dec. 99 T-bonds (USZ9), daily. Three-bar high trailing stop. Source: Omega Research.
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Pattern-based To place a pattern-based trailing stop, you look for a logical technical level to place your stops. For instance, support (for long positions) or resistance (for short positions) are good choices for trailing stops. The theory is that the market should not trade back through these levels. If it does, it is possible the market dynamics have changed. Referring to Figure 3, notice that each time a new resistance level is established, you trail your stop (TS) to just above that level.
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| Figure 3. Dec. 99 T-bonds (USZ9), daily. Pattern-based trailing stop. Source: Omega Research. |
Time stops Many traders view being in a nonproductive trade an opportunity cost. Even though there may not be any losses, capital and mental energy (worrying about the position) are being tied up. In addition, the longer that you are in a trade, the higher the probability that something will go wrong with it.
Because of these reasons, many traders simply exit a market (regardless of price action) after a certain amount of time has elapsed. This method is commonly used by system trader traders and short-term traders. Logically, the approach makes sense because the original reason for entering the trade (say, momentum or a particular chart pattern) may no longer be valid.
Other trailing stop methods
In trading, there are no “exacts” or precise methods. You can use any method or combination of methods for trailing stops as long as they tighten (decreasing your risk) as the market moves in your direction–for instance, a moving average or a Parabolic stop-and-reverse indicator (SAR),2 to name two.
Taking Profits As we’ve mentioned, taking profits is always a dilemma. Ironically, the old Wall Street adage, “You’ll never go broke taking a profit” is exactly how many people do grow broke trading.
For example, suppose you risk on average $300 per trade but take profits when you are $100 ahead. Simple math tells us that you must be right three times as often as you are wrong. This is quite an hurdle to have to jump, considering that many professionals are only right about half of the time. You actually can go broke taking a profit–if the profits are too small relative to the risk you are taking.
So what’s a trader to do? Whatever your trading methodology, you should aim to make, on average, at least twice as much on your winning trades as on your losing trades. This brings us to the next Wall Street adage: “Let your profits ride.” To an extent, this bit of wisdom is true. However, by letting profits ride, your run the risk of watching them quickly evaporate if the market moves against you. Therefore, in addition to trailing stops, you can achieve the best of both worlds by scaling out of positions as they move in your favor. This way you are least locking in small profits, and you still have a chance for much larger profits on the remaining shares or contracts in your position
It’s beyond the scope of our discussion to detail different money management techniques–there are entire books dedicated to this subject. But there are two simple methods, in addition to trailing stops, you can add to your trading repertoire that will improve your chances of success: 2-for-1 money management and taking profits on parabolic moves.
With 2-for-1 money management,3 you simply sell half your position when you’ve made at least twice your initial risk; you then move the stop on your remaining position to the break-even level. For example, suppose you buy 200 shares of a stock at $50 with an initial protective stop (IPS) at $48, for a risk of $2 per share. If the stock subsequently climbed to $52, you would sell 100 shares at a profit of $2 per share (the same as your initial risk) and move your stop to break-even ($50) on the remaining 100 shares. This way, barring overnight gaps, the worst you can do on the remaining shares is break even–and hopefully, the trend will continue and you will capture a much larger profit on your remaining shares through trailing stops.
Taking profits on parabolic moves A parabolic move is a strong move (up or down) in a market that takes the shape of a parabola (Figure 4). Such moves are caused by some sort of euphoria, where participants begin to “dog pile” into a market. In commodities, this kind of activity can be triggered by a crop freeze, a war that could disrupt free trade (e.g., the Gulf War), and so on.
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| Figure 4. Parabola.
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In stocks these moves can result from buy-out rumors, enthusiasm over a company’s prospects (a new drug, a great product), and so on. Take December ’99 coffee, for example. Recently the futures took off, gaining over 40% in a few days (see Figure 5).
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| Figure 5. December ’99 coffee, daily. Coffee makes a parabolic move, running up 40% in a few days. It’s advisable to take at least partial profits on such trades, since they frequently give back much of their gains very quickly, as was the case in this example. Source: TradeStation by Omega Research.
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If you are lucky enough to catch a parabolic move, you should lock in at least part of your profits and tighten your stops on the remaining position because these moves are often short-lived; reality eventually sets in. At these junctures, you have to ask yourself, “Who’s left to buy?” In Figure 5, notice that nearly all of the gains were wiped out over the next few days.
Putting the pieces together
Figure 6 is an example of using a pattern-based initial protective stop, a
two-bar trailing stop, 2-for-1 money management, and a parabolic move. Let’s walk through it.
On 6/28/99, Microsoft [MSFT>MSFT] formed a cup-and-handle pattern. We go long above that high at 87 (a) as it begins to rally out of its handle. We place our initial protective stop (pattern-based) below the lowest low of the handle (b) at 83 7/8 for a risk of 3 1/8 points. The stock continues to rally, and at point (c) we sell half the position, capturing our initial risk (3 1/8 points), and then move the stop on the remainder of the position to break-even (d).
We then trail the stop on the remaining shares just beneath the two-bar low (e). At point (f), the stock makes a parabolic move–its biggest one-day gain in months. This is a good time to take more shares off the table to lock in an extraordinary gain. Finally, at point (g) we are stopped out of any remaining shares as the stock trades below its prior two-bar low.
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| Figure 6. Microsoft, daily. Combining several stop and profit-taking techniques. Source: Omega Research.
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While this is admittedly a well-chosen example, it illustrates the possibilities of capturing profits and controlling risk through use of initial protective stops, money management, trailing stops and by taking profits on parabolic moves.
1Shorting a stock, option or future means selling a market to profit as it declines. If you are serious about trading, you should make shorting part of your trading regimen. For more information on this subject, see our article in the Trader’s Learning Section.
2This is a indicator developed by Welles Wilder which tightens stops at a “parabolic”–that is, accelerated–rate. This indicator is programmed into most popular charting packages. For more details, see Wilder’s book, New Concepts In Technical Trading Systems (1978, Trend Research).
3The TradingMarkets.com Guide to Conquering the Trading Markets.
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