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30

Trailing Stops

Trailing stops have the advantage of keeping you in a trade as the market moves in your direction. As the market moves, you trail your stops until eventually you get stopped out. There are several methods that you can use.

Parabolic SAR

The first method is the Parabolic SAR. This indicator was introduced by "Welles Wilder in his book New Concepts of Technical Trading Systems. This method is a trend-following method that is always in the market either long or short. This system is not too bad as long as the market is trending. When the market gets choppy, this method works very poorly. As a stop technique, it works great. It is not the scope of this chapter to explain each indicator and how it is calculated, but here is a brief description of how the Parabolic SAR works.

Figure 6.5 The daily values of the Parabolic. The values are shown as dots. The down arrows above the dots show how well it works during a trend. Using the Parabolic as a stop notice how the stop points follow the market lower. the parameters are .20 step value and 2 maximum.

IPC MEXICO INDEX

07/31/96

3450

3400 3350 3300 3250 3200 3150 3100 3050 3000 2950

f J I •

• * Sell

Exit here

i "

3450 3400 3350 3300 3250 3200 3150 3100 3050 3000 2950

J 08



This indicator has two components: the step, which is the size that the Parabolic will rise/fall as the market makes new highs/lows and the maximum value that the SAR can obtain. As a rule of thumb, most technicians use .20 as the step value and 2 as the maximum value. The Parabolic will continue to rise/fall with time until eventually prices break the Parabolic level and the Parabolic reverses direction (see Figure 6.5). Its shape resembles a parabola as it follows the market up and down.

Once you are in a trade, you can set your stops to the level of the Parabolic and every day thereafter change your stop accordingly. Figure 6.5 shows that as the IPC Mexico Index sells off, the Parabolic follows it down as well. When the market hits the Parabolic point, the signal reverses.

Moving Average

In a similar fashion, a moving average is a great tool for determining stop placement. A moving average takes a series of data points for the past number of days that you determine and averages them. For example, if you choose 10 days of closing prices, you add the closing prices for 10 days and divide that number by 10. As you add the next days closing price, you drop the oldest price, producing a running total of the most recent 10 days.

When you buy and sell, you can place your exit stops at the same level as the moving average, as in Figure 6.6. As the market moves, your stop level automatically follows and you can periodically call your broker to change your stop. There may be times when you enter long and the moving average is above the market, or enter short when the moving average is below. When this occurs, place your initial stop and wait until the moving average moves to the appropriate side before using it to adjust your stops. You can decrease waiting time by using a shorter length for the moving average.

Use a time period for the moving average that is far enough away to prevent a false move stopping you out prematurely, but do not make the moving average value so distant (slow) that you give up a substantial portion of your profits to avoid getting stopped out. If you are trading short-term, a 5- or 10-period moving average works well. For the longer term, a 15- to 25-day period is good. This balancing act has no perfect answer.

There are many different types of moving averages (simple, weighted, exponential, adaptive), so experiment and visually look at the market and time frames and choose the average that works best for you. First try a simple moving average. If you are swing trading and short-term oriented, a more advanced moving average designed to have less lag might work better.* Figure 6.7 shows the difference between a simple and an advanced moving average. Notice that for the same number of days, they look very different. Compare moving average types and lengths to find the one that works best for you.

* Some simple low-lag moving averages are (DEMA) Difference Exponential Moving Average and (KAMA) Kaufman Adaptive Moving Average. More sophisticated versions include the Kalman Filter and (JAMA) Jurik Adaptive Moving Average.



Figure 6.6 Using a 10 period moving average. If you use this average as your exit stop, your trade is exited when price breaks through the moving average line.

Incremental Approach

The third type of trailing stop you can use is the incremental approach. This is where you adjust your stops incrementally and on occasion, not on every bar. When a position is initiated and you have your initial stop in place, wait for the market to either move or close by a certain amount beyond your stop and then raise your stop by a predetermined increment. For example, every time the S&P 500 closes by one point or more beyond your stop, you might raise your stop by 0.25 ticks until eventually you are stopped out.

The second approach takes into account intraday moves. For example, whenever the S&P 500 moves one point or more beyond your entry, you place a stop at point from your entry. As the market continues to move by one point, you continually raise your stops. If the market does not move, you keep your stop until you get stopped out or you exit for another reason. This is a great technique because it lets the market move in your direction before you take any action with your stops.



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