I haven’t yet turned the central heating on and my kids are already whipped up into a frenzy about Christmas.
My 6-year-old, who usually has to be bribed to pick up a book, has turned into an avid reader of the Argos catalogue, helpfully adding a yellow Post-it note to any pages bearing goodies that he’d like to find in his stocking on Christmas morning.
My wife and I have learned through bitter experience (of buying so many large plastic toys that we’ve had to move house), to pay little heed to what the kids say that they “want”.
Knowing what we want is – I’d hope – something we get better at as we get older. But it would seem, not always …
A few weeks ago I was talking to someone from one of the big spread-betting platforms.
He was telling me that number one on their clients’ wish list for platform features was trailing stops.
So, they launched a trailing stop feature and (guess what?) No one uses it! It would seem that traders have a bit of a love/hate thing with trailing stops.
I’m guilty myself – I often hear myself extolling the virtues of trailing stops, yet I rarely use automatic ones in my own trading.
Perhaps it’s time to work out how we really feel about them…
How trailing stops work
First off – what exactly are trailing stops?
In essence they are a dynamic stop loss level – that moves with the price of the instrument you’re trading.
Let’s say you’re buying GBP/USD at 1.5843 and you put your stop in 30 pips below at 1.5813.
Now, let’s say that the price moves up to 1.5883, bringing you 40 pips into profit.
If your stop loss is a trailing stop, it will move up with the price of the instrument – so your stop loss will now be 40 pips higher, at 1.5853 (10 pips above your entry level).
In this way, your trailing stop has locked in some profits, so if the market suddenly turns tail in the other direction, before you’ve taken your profits, you’ll still have secured some profits on this trade.
Trailing stops are a great way to protect profits and minimise losses …
Like all stops, they aren’t an automatic solution to prosperity and can have their drawbacks…
The pros and cons
Trailing stops may sound like the answer to our prayers – allowing us to cut losses and let profits run. Surely what every trader wants?
Unfortunately, in themselves, trailing stops won’t make you a more successful trader…
But they can cut down on emotion-driven trading errors… they can help combat greedy trading… and they can calm our trading nerves.
However, they also “dangle” from our trades at arbitrary levels, following behind price movements with no nod to market dynamics or technical analysis.
Their biggest drawback is their propensity to knock us out of trades when the price has a little wobble. No price moves in a straight line, and a trailing stop greatly increases your chances of getting knocked out by the natural ups and downs of the market.
That’s why the distance of a trailing stop from the price level needs very careful consideration.
If your trailing stop is too close, the market does not have enough room to breath, and regular price fluctuations are very likely to hit that stop prematurely.
So, should your trailing stop be 5% away, 10%, 25%, 50%?
Unfortunately, there’s no right answer.
The volatility of the instrument you are trading is paramount.
Trailing stops should be placed at a distance from the current price that you do not expect to be reached unless the market changes direction. If that instrument usually fluctuates within a ten pip range while it is still trending in one direction, you would need a trailing stop that was larger than 10 pips.
Love ’em or hate ’em
Some traders swear by trailing stops, and others (usually those who’ve had their fingers burned by turbulent markets) give them a wide berth.
For the rest of us, there is some middle ground.
Many traders I speak to who do use trailing stops will only apply them once their position has moved into profit.
Personally, I’d favour manual trailing stops over automated ones.
To implement an automated trailing stop, all you need to do is set up that function on your trading platform, choosing the amount of pips by which the trailing stop will follow the market price if the trades goes in your favour.
By contrast, to perform a manual trailing stop, you have to actually move the stop yourself to lock in profits as the price moves.
I prefer doing this manually because I can then move the stop loss according to how the market moves with respect to support and resistance levels – rather than an arbitrarily chosen number of pips.
Of course, this means actively managing your trades, which I appreciate that many of us don’t want to spend our time doing.
If you do use automated trailing stops, remember that their levels have no basis in technical analysis, so – if you have the time – a little tweaking around support and resistance levels wouldn’t go amiss.
In the next seven days…
According to the weatherman, next week will herald the arrival of winter, with a chill wind blowing in from the North Sea, and snow expected on high ground.
Fitting really, when we’ve the long-awaiting spending review announcement on Wednesday, which insolvency specialist Begbies Traynor tell us will put 50,000 companies at risk.
We can expect some downbeat numbers from the US, with industrial production figures on Monday, Housing starts on Tuesday, and the Philadelphia Fed Manufacturing Index on Thursday.
And yet, despite all this gloom and doom, the markets are still charging ahead. Most likely this is based on the expectation of further quantitative easing to be announced by the Fed early next month.