Of all the professional exit strategies, the most widely used would have to be the trailing stop. This is the best way I know to make triple digit gains. The trailing stop is ideal for letting a profit run, while at the same time, giving you a clear-cut exit point for when a stock turn lower.
Well, I’m going to show you in this video. You’ll learn the limitations of a simple percentage based trailing stop, and I’ll explain the method that many of pros use. You’ll also hear about the special tweak I make to my own trailing stops. If you can master the art of this professional exit technique, then you could open the door to some amazing profits.
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Okay, so I recently got a great question from a member of my trading signals service. It was about trailing stops and calculations I use to set them. Here’s what he asked…
“Question on trailing stops: Most appear to be around 25%. But some are much more — for example 40%. Can you give any insights to how stops are decided?’
That’s an excerpt from an email a member sent me. It was the inspiration for this two-part series on trailing stops. If you missed the first one, go back and watch it. I explain the key mechanics behind a fixed percentage trailing stop losses. This is a great strategy for maximising upside and providing an exit point. It’s also a method you can readily apply yourself.
Okay, so this video takes trailing stops to the next level. I’m going to explain how many of the pros use volatility in the calculation. This will give you a new perspective on the exit strategy.
Now as you know, stocks trade within a daily price range. For example, today’s range may be $4.00 to $4.10, and tomorrow’s could be $4.04 to $4.12. The range is typically different each day.
Now, a single range doesn’t tell you much — it’s just a high and a low. But a series of ranges is different… it can tell you a lot about the current trading conditions and helps you prepare for what could happen next.
So here’s what many of the pros do, they calculate an average trading range, or ATR, for each stock. This provides a guide to share price volatility. They then use the ATR to set the trailing stop.
Have a look at this:
The graph shows a trade from in Zip Co — a buy know pay later business. And so you know, I’ve chosen a relatively volatile stock for this example. This will help show you the potential advantage of using a volatility based trailing stop.
Okay, let me explain what’s going on… a key point for any trailing stop is the share price high. This is the level from which you calculate the exit price. The share price high is a fixed point until the shares reach a new high. For example, if a stock hits a peak of $5, the trailing stop will “hang” below this point. It will continue to do that until the share price makes a new high above $5.
I’ve marked two sets of share price highs on the chart. There are of course many more highs within this trade — I’m just highlighting two for this example.
Now, the first figure on the graph is 52%. This is the distance between the share price high and the trailing stop. Just to the right, you’ll see 35% — the gap between the high and the stop is smaller. And remember, the trailing stop calculation for both exits uses the same share price high.
So why is the gap narrowing? Well, it all comes down to volatility… have a close look at the share price in the lead-up to the high. There are several big trading ranges as the stock surges upwards. ZIP more than triples its value in four months.
A professional trading strategy will respond to the greater volatility by widening the stop. The purpose of this is to reduce the odds of the larger trading ranges triggering an exit.
You could think of it like a jetliner flying into turbulence. The pilots will often climb the aircraft to a higher altitude to avoid a bumpy ride. The average trading range trailing stop is doing something similar.
The opposite happens when volatility falls. Rather than giving a stock extra room to move, the trailing stop will come in closer. The aim is to minimise potential downside.
Have another look at the chart:
I want you to focus on the gap of 35%. Notice how the trading ranges get smaller in the weeks prior. This is the catalyst for tightening the trailing stop. The calmer conditions render the wider stop unnecessary.
You’ll see another example near the end of the chart. Again, volatility rises leading into the high. And it remains elevated as the stock pulls back. But then the shares begin to stabilise, and the trailing stop starts to edge closer.
If you’re wondering, I calculate the average trading range over the previous 30 trading days. I then multiply this figure by 10 to generate the trailing stop’s width. It’s then just a matter of deducting the width from the prevailing share price high.
It important to note that these are magic numbers… other combinations will also work. As I said in the first video, it’s important you know what you’re trying to achieve. Short term traders will typically set relatively close trailing stops, while medium to longer term traders will allow more breathing space.
I also use a special extra feature in my own trailing stops. The closest it will get to a stock’s high is 25%. This provides a trade with breathing space when volatility is low. What I’ve found is that volatility can sometime get very low during a period of consolidation, and this can trigger the trailing stop unnecessarily. Have a minimum width for the stop helps to avoid this.
So, is the average trading range method better than the percentage based method? Let’s start with a few stats from the average trading range method… the widest gap between the share price and trailing stop was 56%. The narrowest point was 27%. And the average was 42%.
Some people will say this is too wide. They simply aren’t comfortable giving a stock this much breathing space. And that’s okay. You can set your trailing stop closer if you prefer.
But remember, a lot depends on your goal… my trailing stops are wide by design. The aim is to maximise the time in large price trends. This is how I stays in some trades for well over a year. If you’re targeting shorter term moves, then faster acting strategies may be more suitable. But if it’s big trends you’re after, I believe you need to give them room to move.
Now, let’s go back to the stats you saw a moment ago… these figures will be different for every trade. Many stocks will be considerably less volatile than ZIP and have closer trailing stops, while others will have higher volatility.
And this is the beauty of the approach. By using a stock’s average trading range to calculate the trailing stop, you create a unique exit for each trade. It’s a bit like comparing a tailored suit to one off the rack. The ready-made suit will probably do a fine job. But a tailor’s suit may be that little bit better.
Check this out:
This is the same trade in ZIP that you saw earlier. But this time it doesn’t use the average trading range trailing stop. Instead, it has an “off the rack” 25% trailing stop. The result is an earlier exit during a period of sideways trading.
Okay, let’s try this again using a 30% trailing stop:
The wider exit stop helps to stay in the trade longer. But the lack of flexibility still leads to an earlier exit. And that because the percentage stops don’t adjust for volatility. While a fixed trailing stop is a great strategy, it doesn’t get the best results on this occasion.
So does this mean you should only consider the average trading range method? Not at all. I believe the fixed percentage exit is an excellent strategy for most people. Unlike the average trading range approach, a fixed percentage is quick to calculate. You also don’t need a pile of data and a spreadsheet. An everyday calculator will do the trick.
Sure, it’s not as tailored as an average trading range exit. But the fixed percentage method achieves the same purpose: It lets your profits run, and it gets you out when the trend turns. And best of all… you have the know-how to do the calculations yourself.
Many people don’t have a strategy for selling. But you do. I hope you take full advantage of it.
If you’d like to learn more about my strategies, I’m about to host a free skills accelerator course. I’ll be teaching 5 key tactics for identifying, managing, and exiting high potential stocks. You’ll find all the details at my website: motiontrader.com.au.
As always, if you enjoyed this video and thought it was valuable, then please click the like button and share it with your friends. And be sure to subscribe to my channel and click the bell icon for notifications. Thanks for watch, I’m Jason McIntosh, and let’s find some trends this week.