There is much to be learned from trend following traders. Although their strategies are not widely accepted, their discipline and mechanical approach to trading is second to none. “Cutting your losses” is perfected by trend followers. A vital ingredient in that equation is the use of trailing stops. The following is an excerpt from the autumn gold blog:
Trailing stops are often used by trend-followers to protect at least a portion of a position’s profits. A stop (as opposed to a stop-limit*) becomes market order once hit. Because stops become market orders once the price has been reached the execution price could be higher or lower than the original stop.
Many medium and long-term traders will place a stop loss after their initial order has been filled. A sell stop below the market for long positions and a buy stop above the market for short positions. These stop can be set according to a number of different factors such as the total risk the CTA is willing to make on one trade, the support and resistance levels of the markets, market volatility, and other market factors.
As a position becomes profitable, a CTA may raise his stop as the market goes higher or reduce his stop as the market goes lower. That way the CTA “protects” a portion of his profit. These “moving” stops are known as trailing stops.
Let’s use the Comex gold as an example. A CTA who buys gold at $935 determines that the next support level is $920. He sets his stop at $915 and risks $2,000 per contract.
Over the next month the price of gold rises and is now $960 a contract. The CTA cancels his original stop and now places a “trailing stop” at a higher level, let’s say $945. If he gets executed on his stop he protects $1,000** of his profit.
The price of gold continues to rise and is now $995 a contract. The CTA moves his stop to $975. If he gets stopped out he protects $4,000** of his profit.
The conditions we described above are ideal conditions; the market moves for a sustained period in a general direction. As we all know market conditions are rarely ideal. Trailing stops often depend upon both time and price. If the markets move very quickly in one direction over a short period of time (such as hours or days) the trailing stop may not have kicked in yet and it is possible for profitable trade to turn into a loss.
Each CTA has their own system for handling trailing stops. Some high frequency CTAs use time and the markets to exit the trade rather than use stops at all. Asking your CTA about what type of risk they take per trade and how they get out of the market will help you monitor their trading more effectively.
* A stop-limit order becomes a limit order once when the stop price has been reached and can only be executed at that or a better price.
** Since stops become market orders when hit, investors may be executed at a higher or lower price.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.