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.

The profit-target strategy has worked better in this market, but the trailing stop has made money as well, and in other markets the trailing stops have been better (you will have to take my word for this as I can’t post all the charts). The key point is that both have worked — they both make money when the market is trending. This suggests to me that there is no right answer here. When there is a fast-moving trend that runs for a long time, the trailing stop will do better; when the trend has a lot of reversals, the profit target will be better.
This has made me feel much more confident about taking profits. I kept wondering if I had failed to take profits in the right way on my trades, but actually, it looks like there isn’t a wrong way, and I feel much less bad about “giving up” profits on occasions when one method or the other has got me out too early.
So how should I take profits from now on? I think the following should work:
  1. Start with a 2 ATR profit target.
  2. If the market is running strongly, stay in the trade beyond 2 ATR but use a trailing stop.
  3. 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.
And now that I have this new indicator, I will check it for each trade, so that I will know if any particular method of taking profits has failed to work in a particular market.