About a month ago, we posted an analysis that turned out to be both 100% correct and 100% wrong. Quite the paradox, right?
What I mean is that after-the-fact look back at that analysis shows that:
A trader who followed the signals that the analysis produced made money
A non-trader who looks back at the analysis probably thinks it was wrong
This demonstrates a very important aspect of trading in general, but rarely is a very clear example available to illustrate it. So, we’re lucky, because we’re going to learn something about position management today.
Let’s start with a true story. Back in December, a friend asked what I thought would be a good buy, and I said Litecoin – which was trading about $16 then. We didn’t discuss Litecoin again until a few days ago, when this same friend noted that LTC is now back below $16. In fact, following that, LTC proceeded to fall as low as $10.70.
So, was the recommendation to buy at $16 good advice, or bad advice? Let’s look at a chart:
If your analysis shows that price will go up, and you buy at the right time, and it does go up, then you should make money. This should be true even if the price later falls to below what you paid. Logically, that makes sense. But in order to actually do that, we need a good methodology for managing where we sell. This is the concept of the trailing stop loss.
First entering your position can be done according to the Trade Execution article. So, if we were trying to enter at $16 as described above, we would have done so and placed our stop below the recent low plus Average True Range, here:
As an aside, that’s a huge stop. If you’re willing to manage the trade on 4-hour bars (that means moving your trailing stop up on 4-hour bars instead of daily bars) you can use 4-hour bars for your initial stop loss. That would be smaller, and looks more like this:
That seems a lot better (a smaller stop means you can buy more for the same risk percentage), but since we’ll be managing our stop on a lower time frame, it may or may not make more money in the end — we’ll likely get stopped out sooner as a result. Understanding that time-frame trade-off is really important.
In either case, the stop is about to get a lot smaller as soon as we get some movement in the right direction, because we’ll be using a three-bar trailing stop.
For illustrative purposes, we’ll follow both of these examples (Daily and 4-Hour), starting with the Daily one.
Firstly, you start with a trailing stop as soon as the first minor pivot is exceeded. This pivot should be the one nearest the price at which you would feel confirms a move in the direction you expect. Since we’re entering at $16, I think the previous day’s high which comes in at $18.77 is fairly reasonable:
If we get above the pink line, I’d say that should be far enough that I shouldn’t actually lose money on this trade anymore. At that point, I’ll sell a portion (1/3) of my investment and move the stop to break-even:
By selling 1/3 and moving the stop to breakeven, you (mostly) guarantee a profitable trade. You’re now trading on the market’s money, not your money. You also have cleared your “risk budget” and now have room to add more new trades.
At the point at which the minor pivot is exceeded, we also switch to a 3-bar trailing stop. This is defined as the lowest price of the last 3 bars from (and including) the most recent high, excluding inside bars. An example should make that clearer:
I’ve shown the 3-bar trailing stop level in blue. Starting from the recent highest bar (last candle in the above chart) and counting back 3 bars starting from and including that same bar, the lowest low of those bars is the blue line. None of those bars are inside bars, included in the previous bar, so it’s that simple.
Because the blue line is above our current stop, we move the stop up to that level instead. We never move our stop down, only up:
The amber line represents our entry price, and the red line represents our current stop loss. Everything’s good so far, so now let’s move time forward by one bar:
This was a nice profitable candle. If I’m really happy with profits right now, I might just close the rest of the trade and walk away rather than risking a collapse back down to my stop loss. Usually though it’s best to leave at least some left for a long run, so it’s perfectly acceptable to close the next 1/3 of the trade here. In either case, this made a new highest bar, so we count back 3 bars again to get the new stop loss shown above.
Now, we just wait until we either hit our stop loss or get a new high. That doesn’t happen for awhile:
Since none of these bars either (1) hit our stop loss, or (2) made a new high, we do nothing.
The next bar after these, though, makes a new high, so we count back 3 bars again and move our stop loss to the lowest point of the three bars:
At this point, we’ve locked in a lot of profit, and we’re still in the game. We probably wish that we didn’t already sell 2/3 of our position by this point, but not all trades work out as beautifully as this one did, and the cash flow and risk control from higher-probability exits helps a lot.
Now what happens?:
Looks like they knew where we were hiding. Actually, a more robust trailing stop also incorporates some element of the ATR, just like we did for the initial stop loss level. Having some ATR buffer around your stops usually helps to avoid stop gunning like this (using ATR/2 is decent). Sure, it means wider stops, but that’s why we’ve been taking profits so far.
As far as active profit-taking, there were a few big price targets hit on that last candle, actually. You don’t have to (and usually never should!) wait for a trailing stop to take you out once you’ve hit a great price target. (Or, you can move your trailing stop in very close – same thing):
But, anyway, let’s assume that we did indeed get stopped out at the original 3-bar trailing stop shown earlier. Assuming a $10,000 account and 1% risk, what ended up happening?
- Entered @ $16, stop at $9.68. Bought 10.74 LTC.
- Exit 3.58 LTC @ $18.77
- Exit 3.58 LTC @ $24.00
- Exit 3.58 LTC @ $23.00
For an average exit price of $21.92, for a profit of 10.74*($21.92 – $16.00) = $63.58 = 0.64% in 15 days. That’s a very small profit, but it was very low risk, and still represents about 17% profit annualized, so it’s not terrible.
But, I prefer 4-hour bars. Let’s do the same trade on 4-hour bars.
We start off with an entry at $16 and a stop at the recent low minus 1 ATR (calculated at the bar where the low occurred). The ATR in 4-hour bars is about 1.85, so the stop is at $13.54:
Nothing happens until we hit the minor pivot at $18.77, at which point we sell 1/3 of the position, and switch to either breakeven or a 3-bar trailing stop, whichever is higher:
A new high bar, so we move the stop up again:
Same thing. This time we also hit a price target and sell another 1/3 as soon as that target is hit ($23.04). We leave the rest for either another really nice target or the trailing stop:
We get a new high, so we move the trailing stop up. In this case, we ignore a bar because it’s an inside bar of a previous counted bar — that is, the bar that we have labeled “2” completely contains the ignored bar. In a nutshell, we ignore a bar when ignoring it would place it completely inside of any bar which is later included in the final count (it’s a recursive algorithm). There are a some minor details with this rule but they’re not usually very important.
That leaves us with this:
Another high, another stop:
And we’re stopped out:
Again assuming a $10,000 account and 1% risk, what ended up happening here?
- Entered @ $16, stop at $13.54. Bought 40.65 LTC.
- Exit 13.55 LTC @ $18.77
- Exit 13.55 LTC @ $23.04
- Exit 13.55 LTC @ $21.60
For an average exit price of $21.14, for a profit of 40.65*($21.14 – $16.00) = $208.94 = 2.09% in 5.5 days, for an annualized profit of about 295%. Much better.
Finally, these examples showed long-side (bullish) trades, but all of these techniques apply equally well to short-side (bearish) trades. They are also scalable, which means that they automatically scale to changes in market volatility.