Trailing stops can be a contentious issue for both systematic and discretionary traders. Some traders swear by them, while others can’t stand them. If you’ve been in the market more than five minutes you’ve probably been through the experience of having a trailing stop take you out of a trade at the very moment, you should be adding to the position. Isn’t it always so easy in hindsight?
For what it’s worth, here’s what experience has taught me:
Do you have a specific target in mind?
If there is an obvious target for the trade, you should give it room (and time ) to move. The market has a way of eventually reaching a target while frustrating as many people as possible in the process. These types of trades need space.
In fact, for trades with a target, it can be worth making the outcome binary and only exit at either the initial stop or the target. Moving the stop to breakeven is going to get you stopped out of a winning trades just as often as its going to protect you from a losing trade.
In the pic below, we would probably have been stopped out by a trailing stop long before the trade reached its target. Remember that when we entered the trade, we had a reward to risk ratio of about 2.5:1. A trailing stop effectively ruins our RR ratio, because the trade hasn’t breached that initial stop level, and it hasn’t been given room to reach the target.
Thoughts on using Trailing Stops
Momentum
If you buy a stock based on momentum (say after a breakout) but have no idea how far the move may extend, it’s a different story. Since you are buying based on momentum, you should only hold the position while the momentum continues. For these types of trades, I find a combination of trailing stops and scaling out along the way works best.
I tend to scale out either at targets based on the initial risk or when momentum reaches an extreme. For instance, I’ll usually aim to sell a third each at two times, three times, and four times my initial risk. If however, I see an oscillator in extremely overbought territory, I’ll sell a third there, rather than waiting for the next target. A wide range bar is also a good place to offload part of the position as it may signal a buying climax, and you don’t want to leave all your profits on the table.
As for the trailing stop, I don’t use a specific moving average, but which ever average seems to contain most of the price action. If that MA is breached, I will sell a third, if it falls further I sell another third, etc.
A trailing stop on a momentum trade should be close to the price action. If you bought it as a momo trade, you could be sure you weren’t the only one. So, you have no idea how many other traders are going to be heading for the exit, and you might as well be one of the first out.
The Trend Following Approach
Finally, you might be following a trend if you believe the prior trend was convincingly broken. If you are following the trend, you are going to hold onto the position until the evidence suggests that the trend has been broken.
Again, I like to scale out as the evidence of a trend break develops. If I see a new swing low, I exit a third and then see what happens. If it retests the break and stalls, that’s also a good place to exit another. If the price, then makes a new low its time to exit the remainder. Buy scaling out as the evidence against your trade mounts, you still have a position if the break turns out to be false.
Conclusion
The key to all this is to know what type of trade you’re entering and manage it accordingly. There is no right or wrong way to use trailing stops, and there’s definitely no magic indicator. Decide what type of trade you are entering and the appropriate exit strategy, and then stick to it.
On the chart to the left, we would probably have been stopped out by a trailing stop long before the trade reached its target. Remember that when we entered the trade, we had a reward to risk ratio of about 2.5:1. A trailing stop effectively ruins our RR ratio, because the trade hasn’t breached that initial stop level, and it hasn’t been given room to reach the target.