Trailing Stops



Once a position has gone in a traders favour, you may want to let your profits run whilst using a trailing stop to lock in profits. This will all depend on your TESTED trading strategy.  Your strategy may require you to let the trade develop to hit your reward to risk ratio, or stop out.

There are many ways to configure trailing stops within your trading strategy. The simplest stop is a fixed trailing stop. This is where traders enter a position and the trailing stop follows behind if the position is going for you. Once the position moves against you the trailing stop fixes itself until the trade stops out.  If the trade doesn’t reach the trailing stop and the trade continues for you, the fixed stop will continue to trail the position.

There are many ways to set trailing stops.  The following list highlights just some of the ways of doing this:
  • You can set percentage trailing stops (shown below)
  • Set a trailing stop by subtracting or adding a specific amount to the previous closing price (shown below)
  • Place a trailing stop above or below the last periods close (depending on the trend)
  • Place trailing stops close to moving averages - shadowing them
  • Follow support and resistance levels - setting trailing stops on the next support or resistance level
  • Use Parabolic SAR to set trailing stops
We'll look at the first two methods below.  Trailing stops and stops in general are crucial to any trading strategy. If things go against you, with a stop/loss you know that you’re losses will be limited. When looking at trailing stops, volatility is key. Accounting for volatility stops premature stop-outs, so the trailing stop should be aligned with volatility. We've already looked at The ATR in setting stop losses, but we'll go through some of it again in the following paragraphs.

Setting Up a Simple Trailing Stops

A trailing stop follows the price by a specified value from said price. If the price reverses against you the trailing stop freezes and can eventually stop a trader out (your position will close). Some trading platforms will calculate a trailing stop for you on your input and automatically amend the stop at every period. Many don’t though, so it’s good to know how to set them up manually and to manage them yourself on a regular basis.

First we need to calculate volatility, using Wilder's Average True Range (ATR).  We also need to know:
  • Our risk multiplier.  The average risk multiplier is 2, but it can be 0.5, 1, 3 etc... all depending on your threshold for risk and your trading strategy.  We talked about this in Setting Stop Losses
  • The last periods closing price
So to calculate our current periods trailing stop we use formula:

Trailing Stop = Previous Closing Price +/- ATR x Risk Multiplier 

So, if the last periods closing price was 50, the ATR is 0.75, you think the market will increase and you go for the average risk multiplier 2 your trailing stop will be:

{50 - (0.75 x 2)} = 48.5

You can re-calculate the new trailing stop on every new period, or whenever you feel you need to.  This Trailing stop needs to fit in with your strategy, reward to risk ratio, etc...  If it doesn't then don't trade.

Setting up a Percentage Trailing Stop

This is pretty much the same as above, but here we use a trailing stop that is a percentage of the last periods price.  One possible formula is:

{(ATR or ADV) x Risk Tolerance multiplier} / previous closing price = Trailing Stop %.

Let's plug in the same numbers as the above example.  

{(0.75x2) / 50} = 3%

This means that the trailing stop needs to be placed 3% below the last periods close. Remember this trailing stop must fit with your exposure of <2% capital and with your reward to risk ratio.

Reasons to Adjust your Stop Order

During the life of your open trade, it may be a good idea to adjust your stop under certain circumstances, as long as it's in accordance with your original stop order placement rules. Eg. If you are bullish on a market your stop order will be below price somewhere, depending on your rules (maybe one of the above strategies based on volatility).  You entered the trade on an RSI oversold indicator and had a wide stop to let the trade breathe. If the market goes for you and travels into RSI over-bought, it may be time to narrow your stop order as the likelihood of a retracement or reversal is possible. 

Now, this all depends on your overall trading plan and system.  You may be happy to allow price to drop a little if you think the price is a retracement, prior to shooting on.  Narrowing your stop in this case may not be beneficial to your system.

To Sum UP

In both the above examples the formula can be amended to suit your trading strategy.  In any case we need to make sure that we don't get stopped out too early.  Getting stopped out too early affects your strategy and may mean over all losses.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course. <<<<<<< HEAD