Forexology

Before i begin, i would like to define trailing stops so that we are all on the same page.

There are different usage patterns as to how one moves and manages their stop losses and therefore they tend to coin them differently.  Breakeven stops(moved to entry price when profitable), Trailing stops(continuously moves in the direction of the order when profitable and after having surpassed the initial trailing stop gap), Jumping stops(”jumps” by a certain level whenever a certain condition has been met) and Percentage stops(stops that are managed as a % level of the profits left on the table)

For the sake of this topic, i won’t go into the literature of what each stops are and how they can be best managed. As long as your trading plan includes  having a stop loss level which moves as the market progresses, this involves you and you need to read this.

Moving your stops – Does it help?

Yes it does. In fact, for many of our trend following systems, we do have a habit of moving our stops and letting the trends ride itself with absolutely zero or minimal risk.

We do this for 2 reasons;

1) To protect our profits/risks against a whipsawing market
2) To realize larger profits should the market give you one of those monster trends.

Now, so why does it hurt to have stops that move?

If those reasons above are the reasons why your trading plan incorporates such a mechanism and you trade using which always, i can assure you that you have gotten it at least partially correct.

The sad news is, you will be losing money, or not making as much profits in the long run. What???

 

Yes. This is true and accurate.

Almost a year ago, Max Ong(Biz partner and Director of Technology) and I, were thrashing out the concepts of trailing stops and systems with no such management. Ever so often, we get into the debate of  “myths of manual trading”. Just because someone said so or we read it in the books and “think” it works, we stick to it all the time. However, what if we can know, for sure, if certain stuffs work or not.

This is Max’s specialty. I mean, he is a whiz at programming. Give him some logic and he will sit on his computer and start “spraying”(i use spraying because he types at an unbelievable speed) the keys and bham, we are done. A new EA created in like what, 45 mins? Gosh, he is good.

Anyway, so he will put the logic at work and have conditional parameters which plague our doubt. Then, based on simulated market trading(backtesting), we are able to have 2 sets of data. One with our conditional parameter and the other, without.

Here are the results and i am sure a picture tells a thousand words;

The picture is conclusive and from what you can infer, yes, trailing stops do not overall give you more profits. However, they do control your downside(drawdowns) as you can notice the long valleys/spikes downwards are shorter with those which have had trailing stops and those that didn’t.

Of course, after this discovery, we got into our usual “healthy” arguments on how auto trading can be fallible and Max was saying that manual trading is fallible and so on. Eventually, we got beleaguered by our own findings and we had to seek more holistic answers.

The Search for the Truth

In doing so, we asked our other biz partner, Dr. Tham for guidance about this discovery. Dr. Tham, as most of you might know, is my business partner and Director of Psychology. He helps our trainees(and in this situation, even us ourselves) stay focused and have a winning mentality rather than to believe in myths and bogus claims.

He was delighted of our findings and it further cemented his belief and skeptical views that much of what is out there in the market is not what as they claim to be. The test is in the pudding and with numbers to back it  up, there is just no 2nd guessing anymore.  Much to my surprise of learning about the QWERTY Keyboard from him, on how intentionally it was meant to be an inferior keyboard layout, we began to further complement our believes that knowledge and theory from books and experts can be great, but not necessarily relevant to your style of trading.

So why are you telling us about all these now??

Most importantly, what made me write this article today is that what we had figured out and is sitting amongst truckloads of reference material, has been brought to light by another famous trader and his circulars.

In Dr. Van Tharp’s circular, of whom both Max and I are great fans of,(I am also a fan of his attractive cousin called Nanthini, which is another story altogether), we had a publication today making exactly the same claim;

“The bottom line is that breakeven stops are psychologically comforting.  Moving to breakeven allows us to mentally “play with the market’s money.”  However, under most scenarios, it seems that breakeven stops are not helpful in making trading profitable.” — D.R. Barton. Jr.

Conclusion

Note that i am not saying that having trailing stops are not at all counter productive. They do help reduce drawdown at best, so if you are a risk averse trader and protecting your capital is key, it does serve a very important purpose here.

So, should we or should we not use trailing stops?

Well, the devil is in the details. This brings us back to the balance of having enough “risk” to catch more “rewards”. You see, when you trail your stops with too tight a gap, chances are you might get stopped out and if you trail your stops with too wide a gap, you might lose much of the floating profits you could have realized.

There is a proven method as to how much of a a “gap” between the current price and your stop loss will give you an optimal buffer to move within, so that your stop losses will not be taken out prematurely, yet there is an opportunity to harness more profits should the market march on in your direction.

More importantly, for my team and I, it proves that we are in the right course of direction and how the combination of methods, technical backtesting and overall market psychology, each one area contributed by each one in our team, has combined to the greater whole. Again, this shows that we are ahead in our quest for profitable trading systems. That sure helped the ego trip.