There have been many interviews with top traders and speculators, and they all seem to have a similar belief. While each one has their own method for generating buy/sell signals (entries), almost all agree that there is no such thing as the perfect exit strategy. It almost seems that the "Holy Grail" of trading has nothing to do with the trades themselves, but with how you get out of them.

The "science" behind stops is even more difficult than the science behind entries. General trading success occurs by a time-honored belief of "Letting your Profits Run and Cutting Your Losses Short". The problem is that the point of entry doesn’t determine a profit or loss, only the value of the exit determines actual trade success or failure.

This leads into an interesting reversal of ideology. We spend all our time looking for great trades that can never be determined until the trade is over. This forces us to examine the exit BEFORE the entry ever takes place. Knowledge of the exit is now a required part of the entry signal.

The question then becomes "Is there a universal exit rule that is always successful?" Unfortunately, the answer is no. While an exit strategy doesn’t necessarily have to be custom made for a particular entry technique, it will need to be evaluated for its appropriateness to the entrance technique. Stop strategies change in different time frames (days, weeks, or months), and for the type of market they’re used in (trending, short-term cyclical support and resistance, or a volatile market). Often (but not always) a stop-loss/exit strategy that works can successfully be moved to other trading systems within its own time frame and market type.

With more people entering the markets and using computers, the philosophies around using stops have become more convoluted than ever. The techniques for defining stops have been changed to become the trading systems themselves, as opposed to complimenting an already successful trading system. This runs into the same problem that money management introduced. Traders started making money management techniques into the system without realizing the inherent flaws. Money management with a bad system (or no system) will only insure that you lose money faster. Trailing stops for entries mean that you have no real entry signal at all.

Is this message about trailing stops absolute? Can trailing stop calculations be used as a trading system? Well, yes and no. This is where most people get into trouble is trying to use a stop-loss/trailing-stop method as an inappropriate trading system. Trailing stop criteria are designed to lock in a profit once actual profit is achieved. Its purpose is to remove a trader from the market by stating that the validity of the condition of entry no longer exists. It identifies the absence of a tradable state, not the reversal of one. By this definition, a trailing stop method could never be used as a trading system.

However, this is not purely the case for taking profit from a trending market. Typically, trend traders try and capture all trends and are usually in the market all the time (or long on entry signals and out on reversal signals). With a belief that a trend always exists, by definition an exit signal from a trailing stop constitutes a reversal to be used for a short entry.

The problem with this approach is that the trailing stop isn’t determining the existence of a trend to start with, or even the end of a trend, but only to protect against loss while in an existing trend. There is typically no rule within the trailing stop to determine a temporary trend pullback, a correction, or an increase of volatility while the trend is still in action.

What this results in is that the trailing-stop has a dual-purpose for defining a trend. This has been a common approach to many people’s systems. The first techniques with these philosophies were Moving Averages and Moving Average Crossovers. If a price was above a moving average then a bullish trend existed and vice-versa if prices were below the moving average. Crossovers tried to prevent whipsaw action buy using two different time-period based moving averages, but the philosophy was the same. The crossing defined the profit-taking signal, as well as the reversal in the trend.

In a time where market information crept to the traders, this type of system worked fairly well. These days, information can get to anyone almost instantly. The rules that define the trends are the same, but they are much shorter in length and signals are either always too soon or too late resulting in unprofitable trades – except for very long term.

This creates an interesting perspective showing that long-term trends are common, but long-term volatile markets and support/resistance markets are much fewer in comparison. The long-term trending markets are much more forgiving when using a trailing stop method as a trading system so they can often be used successfully. We realize that the short-term approach causes difficulty for the trailing stop to be profitable when used as a stand-alone trading system.

Back on the short-term trading front, we have a few basic philosophies compiled from the market experts.

1. Stay in your position until the trend changes. If you’re in a long position, then you don’t exit on an uptick. This is true even if you have a price target set. Just because a position passes through a price target doesn’t mean that the significant move is over. The position should be maintained until others start trading against it proving that a trend is over. (Note that support/resistance and volatility expansion systems are technically trending systems, just on an extremely short-term level, so this rule still applies.)

2. Get out of the market when the volatility and momentum become absolutely insane. This is usually a sign that things can (and often will) turn against you at any moment, and turn against you HARD. This is the only exception to the previous paragraph, realizing that sometimes you just have to take your profits and run. These types of conditions don’t happen often, but they do happen and can do so with no one to take the other side of your trade.

3. When high volume trading moves to low volume trading, that probably means it’s the end of the trend. Some traders build this into their trailing stop rules, and with good reason. If there is no one trading, there’s no one to keep a trend going. (Low volume at the end of a trend will often lead into a sideways market as opposed to a trend reversal.)

4. Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are willing to lose per contract (or per share). If the meaningful stop point implies an uncomfortably large loss per contract (share), trade a smaller number of contracts (or shares). This means to trade with the market, not with your wallet.

5. Don’t ignore the concept of scaling out (removing a partial position to lock in profits). This is one of the most overlooked opportunities by small traders, and most often used by large traders. This is typically used by determining a price target and then closing out only half of the position at that point, leaving the other half to follow a position as it becomes more volatile without risk of losing existing profits. While not ideal for all trading strategies, it shouldn’t be ignored either.

We hope that you find much of this information useful. Next month, we’ll look at some specific trailing stop strategies that can be adapted to individual trading styles, as well as successful uses of them in system trading.