Friday, December 31, 2010

Q&A Part 2

Q. You mention in your blog that you use an x-day trailing stop. Is there any particular reason you choose this as opposed to a volatility trading stop? And what is your view on the volatility trading stop?

A. The answer here is very boring - I enter positions on an x-day high, so for consistency I use the x-day low for exiting positions. It is also the basis for historically proven trend following techniques, as practised by the Turtle Traders and, going forther back in time, Richard Donchian.

The charts I post on here show that I embrace volatility, in that my scans are designed to ensure that, ideally, when a stock breakouts it also signals an increase in volatility. This should follow a period of consolidation in the stock price when volatility contracts.

Lots of traders use volatility based stops, with I don't deny do have merit. However, I made the personal choice to use the x-day low as the trailing stop.

Footnote: I haven't seen one, but I'm sure there are traders who have simply used breakouts in volatility to enter positions, and a retraction in volatility as an exit signal as part of a trading system.

Q. I often find that when open profits are large it becomes increasingly tempting to cash in my position and sometimes I give in to this temptation, only to watch the market continue to trend after I have closed. Missing out on the extra profits is hugely frustrating. Can you recommend any actions I can take to run my winners longer?

A. The temptation to take your profits before the trend has finished is a form of anxiety that these profits will evaporate and vanish. By the same token (but by no means always the case), the same people also tend to not close losing positions when they get an exit signal, as it signifies that the trader has lost on this position. This is all part of the psychology and trying to be 'right' about the markets, rather than making a profit. In essence, the trader cuts the profits short and lets his losses run, which is the exact opposite of what you should be doing.

Trend following is designed to cut losses short and let profits run to their ultimate conclusion. By the system's very nature, the winning percentage is lower than those system which scalp for small profits, but have much wider stops.

This all comes back to ensuring that your system has a positive expectancy, and I discuss this at length in 'The Trading Triangle'.

It is therefore a psychological barrier that one has to go through when trend following, that you let your profits run in accordance with your system rules, so that, in the final analysis, the sheer size of the winning trades outweighs all the small accumulated losses on the losing trades.

If you find that you cannot do this, then I would suggest looking at using the Uniform Risk Exit, which I have talked about here and also in 'The Trading Triangle'. This will cut back on the ultimate profitability of the system, but is easier on the nerves and can reduce the fear of losing some of the hard earned profits.

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