It’s funny how old clichés often ring true, but then again I guess that’s how they become clichés in the first place. As with most walks of life, we as human beings often need hands on experience, or in many cases pain, to realise the value of advice contained within clichés.
One such cliché in trading circles goes something like, “It’s not when you enter, but when you exit that really counts.” With this in mind, let’s take a look at a couple of exit stop strategies that can help protect profit once it’s on the table.
Static stops like an 8% stop loss or 30% profit target definitely have their place, however for profit targets especially, there are few things more frustrating than setting your target only to watch the market trade to within one tick of it, then to reverse and take out your stop loss. Chart 1 below shows an example of a stop loss and profit target.
Chart 1 - Static Stop Examples
click chart for more detail
There are a variety of ways to implement money management rules to avoid this situation. One of these is to use a trailing stop that will move with the market as it advances, but stay static if the trade moves against you. A popular method is to trail the stop based on the low for long trades and the high for short trades. However, the close or open can also be used. Whether the stock is moving with or against the trade is determined by the field the stop is trailing behind. For example, if a long trade was taken with a trailing stop based on the low, the stop would move higher when the low moves higher than the low of the bar previous and stay static when the low is less than or equal to the low of the bar previous.
Chart 2 - Trailing Stop Examples
click chart for more detail
There are a variety of different types of trailing stops available including price trailing , percentage trailing and volatility (Average True Range based) trailing.
Both price and percentage trailing stops have their place in certain areas, but both need to be tuned to an individual market or stock. This is because $5 may be a very large move on one stock, but an average move on another. The same can be said for percentage moves, 10% may be a drastic move for a low volatility stock, but a fairly typical move for a high volatility stock.
For this reason, volatility trailing stops are often a better approach. Volatility stops work by using prior price movements of that stock to establish stop distances. Using the Stock’s Average True Range (ATR) is one popular method of calculating this stop distance. ATR is calculated first by establishing the stock’s True Range. True Range can be defined as the greatest of either of the following:
- Today’s High minus Today’s Low, OR
- The difference between Yesterday’s Close and Today’s High, OR
- The difference between Yesterday’s Close and Today’s Low
When the True Range level for each interval is known, the level for each interval is then averaged over prior days to produce the Average True Range (ATR).
Based on this, typically ATR stops have two key parameters - the average period to be used and the number of times the ATR stop will be away from the current prices – known as the ATR multiple.
An example of these two is a 9-period average with an ATR multiple of 2. This effectively takes the average true range of the last nine trading periods and then projects the stop by twice this figure behind the current price.
Coming back to the comparison between different trailing stops, the real strength of volatility trailing stops is that they adjust themselves to a market’s current behaviour. This ensures that the exit strategy you are using is tuned to the market in question.
So next time you go to take a trade, it may be worth asking yourself whether you are paying attention to the old cliché and ensuring your exit strategy is sound and clearly defined.