Trailing Stops and the Limitations of Stop Losses

Q. What is a Trailing Stop Loss?


A: This is a stop loss level that automatically adjusts higher or lower as the underlying stock or spread bet instrument moves. So a trailing stop would automatically move up behind the market, but won't move if the price starts retracing back towards it. This has the effect of locking in profits while keeping the spread trade open for as long as possible. For instance, if you are using a 50-point trailing stop loss on the FTSE 100 and you go long at 4300 the stop loss is at 4250. If the index moves up to 4450 the stop loss moves up to 4400. The advantage of using a trailing stop loss is that it removes the need to constantly monitor trades and continually set a new stop manually, as well as locking in profit if the trade goes the right way. Trailing stops are particularly useful when trading a trend.

Q. Which platform would allow me to have trailing stop losses on a spreadbetting portfolio?

A: Most companies like ETX Capital, CMC, City Index, Ayondo allow you to trail your stops YOURSELF. You can't tell them to move your stop loss once the price has moved X, Y, Z in your favour.

IG Index has recently started offering automated trailing stops on currency bets, plus a range of global indices and commodities. The problem with IG is that as they say "Trailing Stops can be added when placing a trade, or attached to open positions at a later stage. Please note they are not 'Guaranteed': like standard Stops they may be subject to 'slippage' in illiquid or fast-moving markets". With Capital Spreads, they don't suffer this "slippage", whereas in a previous life I found IG seemed to build slippage into any stop whatever the volatility.

And as an aside if you're going to use trailing stops, remember to loosen them on increasing volatility and tighten them on decreasing volatility. Most do quite the opposite and on balance, get taken out right when they should be sitting tight, and sit tight right when they should be getting out.

Q. I use IG Index but can't see any trailing stop loss option?

A: That is probably because you haven't activated them on your system. On ig index go to 'my account'-'settings'-'preferences' and tick 'allow trailing stops'. Note that trailing stops are only allowed on standard accounts not limited risk accounts (where you have to have a guaranteed stop). If you want to move your stop manually while watching the trade click on the drop down menu in your open positions at bottom of screen and edit position, just enter the figure you want your stop to be activated at.

You should be able to set a trailing stop at the time you open a bet, or can add/amend later. It's very easy. Initially it might be a puzzle as to how close you set the stop and what 'step' size you use when trailing it - in which case practice by using the tightest settings it will allow, just to see it working, then go for more sensible settings later.

Note the small print and terms and conditions regarding the use of trailing stops at IG Index -:
  1. Our Trailing Stop function is an automated tool that must be used with caution and supervision by you.
  2. Due to the automated nature of our Trailing Stop function, there may be instances in which your Trailing Stop might not in fact move with our current quote for the relevant Instrument/Index, for example:
  3. where our Trailing Stop function (i.e. the systems and technology that operate our Trailing Stops) is down or not working properly;
  4. where our current quote for the relevant Instrument/Index is Manifestly Erroneous;
  5. where there has been a large, short term price movement in our quote for the relevant Instrument/Index that is unrepresentative of current market conditions.

Q. I have a question in relation to protecting portfolio profit...apart from the stop loss, and trailing stop loss strategy, are there any other methods for locking in profits without hurting the chance of further gains? For instance, buying puts on the XJO? Selling SPI futures? If you anticipate a market top, or is this faulty logic...should we just trade with the trend until it corrects us out by hitting our trailing stops...??

A: Hedging is a cost which is why institutions don't do it - traditionally over time you might expect to pay anywhere from 2% to 5% per quarter depending upon market volatility.

Read a bit of Mr Buffet's comments regarding the irrationality of Mr Market...etc

The concept of Mr. Market goes something like this: imagine you are partners in a private business with a man named Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his [the choice is yours]. The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because everything in his world at the time is cheery. His outlook for the company is wonderful, so he is only willing to sell you his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the while, the underlying value of the company may not have changed - just Mr. Market's mood.

The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have to take advantage of him [don't worry, he doesn't have feelings or mind being taken advantage of.] As long as you have a strong conviction of what the company is really worth, you will be able to look at Mr. Market's offers and reject or accept them... the choice is yours.

Q. My query is this; I get into a trade, the trade goes in my favour and then the price comes back, if the price here comes back, would it best to sell out (to preserve capital) at breakeven or let the price go to a couple of % below?

Could I get some views on exits, using BPI as an example? When trading, I'm buying 3k typically at a time, I often am up £200 only to be selling out at a loss of £150. Would traders here be out quickly at breakeven? Obviously sometimes prices can get away from us. This is one of my biggest problems...

A: What would seem to work for you would be to take half off the table when you are in profit and then move the stop loss up to the entry point. If you then find out you're taking profits too early, take less off the table, but still move your stop loss up to entry point. Always another day and another trade, and the next trade might be your best to date.

Q. But are trailing stops useful? What's your opinion on trailing stop orders?

A: I do use trailing stops on IG from time to time, be they daily bets or quarterly contracts, especially on indices/commodities. They let you stay in a trade whilst locking in profits as you go. I prefer it to setting a limit as you can often capture bigger moves, and are ideal for very liquid shares, that tend to have a fairly small spread.

Note: One word of caution: it seems that more spread betting providers are offering trailing stop loss orders. This kind of hints that trailing stop losses may not be a smart choice for traders, particularly for swing traders. Potentially highly profitable positions can be closed all too soon if the stop is not wide enough. Of course, if you're near the top and there is enough momentum for the price to smash through an all-time high, then perhaps a reasonably tight trailing stop loss can help you grab those points before it tumbles. For scalpers/day traders, trailing stop loss order can be useful for quickly locking in profit post-news, but generally it plays on the fears of newbies missing out profit so it helps them to close early....and eventually their account will be wiped out by the poor reward:risk ratio.

Q. In setting trailing stops for downside protection do you have any advice of a percentage and/or methodology that works well for them in regard to getting stopped out in a market blip? I am using 5% as a trigger.

A: Percentages don't work well, always too little or too much. Knowing support/resistance levels doesn't work well, again always too little or too much. For my taste, trailing stops are a strategy to let you more-or-less maximize profit, not a protection mechanism. When I start worrying about minimizing loss, I blow out, now. There is effectively no protection mechanism that won't shoot off a toe now and then. A good approach I've found when day trading is to enter the position, watch it like a hawk until it goes profitable, then set a trailing stop behind it and keep moving it until you exit the position. If you know the issue well enough, you can improve on that... somewhat.

Once in a while you will get stopped out and take an unnecessary loss, but if you know where to set your stop, then this won't happen too often. A sell stop is not an offer to take a loss, but an offer to protect you from greater loss. It's the point where you say 'I was wrong about the trade - take me out of it.' If you're often getting stopped out of good trades, they you're setting your stop too close.

For me it also depends on whether the position I've taken is in the green or red. Also, the size of the position and the volitility. My sentiment factor, somewhat affects this as does the intent of the trade (daytrade, medium or long term hold). I am also of the philosopy of getting out and buying back in.

But even if you have a stop set and you are green and everything is looking good,some ****ing raghead may drive a plane into something and shut the markets down until you are screwed beyond belief.

The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have to take advantage of him [don't worry, he doesn't have feelings or mind being taken advantage of.] As long as you have a strong conviction of what the company is really worth, you will be able to look at Mr. Market's offers and reject or accept them... the choice is yours.

Q. When does one start to trail one's stop? What is your strategy for managing a winning trade?

A: You should move your stop loss levels whenever there is technical logic for doing so. For instance, if you are long and the market makes a higher high and then a higher low and then went back up to another higher high, then you should move your stop to just under the recent higher low, which is a support line. That way, you lock in profits but have a stop that isn't random and is less likely to get wiped out on a correction.

Q. I went to move one of my GSLO's online after the market had closed, only to get a message on the screen that I could not move my stop closer to the market price unless the market was trading. I'm just wondering why?

A: Some spread trading firms will only allow stops to be moved when the market is trading, the same restriction applies to some physical markets as well.

Q. I'm confused - how are stops not a form of protection?

A: In 1987 (aka Black Monday) lots of people thought that their 'stop loss' order would protect them. Instead they just contributed to increasing the avalanche of sell orders, driving the market even lower. Once a stop was triggered it became a 'sell at any price' and queued behind all the other existing sell orders. By the time many such orders got to be executed, the price was much lower then the mere few percent decline specified as the trigger point.

Stops in general also serve as a good protection on short trades, but slippage in worse case scenarios can make your stop meaningless, and 'worse cases' tend to happen much more often than we think. News tends to come out pre-markets, and there are lots of potential events with stocks that will make them gap miles beyond your stop. For instance -:

  • A company perceived to be going bust suddenly gets offered a new credit line or something - could be 50% gap.
  • New inventions/patents product announcements.
  • Takeover bid.
  • Then there is scheduled results - they can gap a stock through your stop by miles.

If, you were using a guaranteed stop and we experienced another event like the 1987 stock market crash, you would be stopped out at the level you specified. You would not incur the 'extra fall' (which is what is referred to as 'slippage'). With non-guaranteed stops, your stop level is not guaranteed. Therefore it could be subject to slippage and which is dependent on market conditions. Unless guaranteed, the 'stop loss' will not be of help in these situations. Note that for guaranteed stops you have to pay extra except for Ayondo which I believe offers free guaranteed stops on most of its markets except individual shares.

 ...Continues here - The Limitations of Stop Losses

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