I was worrying earlier today about whether to use a trailing stop or a profit target. Taking profits is the most difficult thing in trading — you buy on a clear signal, but there is much less often a clear signal that it is time to sell. For a trend-following system like mine, it is often best to sell into strength, but on the other hand if you do that you will sometimes miss the remains of a strong upward trend.
After a bit of work, I think that I have been worrying about this rather too much. The chart below is a little complicated, so I will explain it. It is based on the soybean market. Green lines show the returns from going long, and red lines from going short. The fundamental strategy is to buy, or short, 10-day new highs or lows. On the top-left is a strategy that trades a 10-day new high or low with a stop at one 10-day average true range (ATR) and a profit target at 2 ATR. This strategy takes profits quickly and, obviously, sells into strength. On the top-right are two charts that show the same strategy, but instead of a profit target, trades are exited using a trailing stop, at 2 ATR (upper) or 3 ATR (lower) from the furthest move in the right direction. The lower three charts are pretty much the same, except that the strategies trade re-tests of breakouts.
- Start with a 2 ATR profit target.
- If the market is running strongly, stay in the trade beyond 2 ATR but use a trailing stop.
- Thereafter, take profits with capricious abandon when you have made a lot. That way, you are likely to sell into strength; and if you fail to manage that, the trailing stop will ensure that you still make a decent profit.