The serious downside of the trailing stop loss

I just booked my hire car online for the family summer holiday. As we’re picking the car up in downtown Cannes – it seems that the car-hire firms there are catering to a certain type of client. My choice of vehicles included a Lamborghini Aventador … a McLaren MP4 …at prices that made the Maserati convertible look quite a modest choice at just £5k per week.

In the end, I plumped for the Citroen C4 (more boot space) … but even if I get upgraded to … say, a Picasso … I’ll still have a sense of disappointment that some Brad-Pitt-type is probably driving around the south of France in my Lamborghini.

There’s nothing like seeing what you might have had … to make you dissatisfied with what you did get.

And that’s just how my trailing stop losses are tormenting me …

I’ve long had a bit of a love-hate thing with the trailing stop loss …

I love the idea of them – the thought that I’m locking in profits as the price moves. But I’ve struggled to make money with them.

However, I didn’t want to be beaten. I knew there had to be a way to make them work to my advantage, so I’ve been testing a brand-new system (still in developmental stages) that uses a trailing stop loss.

It’s making great profits – around 25% in the first 3 months – so I should be happy, shouldn’t I? Problem is that it’s causing me to face some real psychological barriers in my trading. I never thought a trailing stop loss could be so painful!

Okay, so first up, let me explain a little about trailing stops, and how I’m using them …

The curse of the automated trailing stop loss

The most basic form of a trailing stop loss is an automated one … this is a button you’ll click on your trading platform. It’ll set your stop loss a set distance away from the price.

As the price moves in your favour … the stop loss will follow it devotedly, locking in those profits. But as soon as the price turns tail, it’ll come and knock out that stop.

In theory, they’ll give you lovely profit runs like this …

In practice, they often end up looking more like this …

This is why I don’t use an automated trailing stop loss – they can leave our stops dangling in the wrong place, where you’d never normally consider placing one.

So, instead, I’ll use an ‘intelligent’ trailing stop loss – i.e. I’m manually moving my stop along with the trade, but am basing its position on technicals.

How wide should a trailing stop loss be?

The whole point of a trailing stop loss is that you’re going to give the market its head, so it can run. The hope being that you’ll catch a bigger move, and bigger profits.

So, putting a tight trailing stop loss on negates that – because you’ll be knocked out of your trade at the first pullback.

So, a nice wide trailing stop loss is better?

Hmmm. Problem with a wide trailing stop loss is that you’re going to have to give back that chunk of profits before your trade closes. And here begins my story of pain …

Trailing stops are all about watching the market move in your direction … seeing those profits sitting in your open-trades account … and knowing that you’ll have to give back a share of those profits before you close.

And it’s a tough feeling to get used to.

Here’s what happened on a recent CAC trade for me …

You see, if I’d taken profits at ‘A’ … I’d have been quite happy with my Citroen level profits. But I saw the Lamborghini-level profits … and then had to give them back, and walk away at ‘B’ with the more modest gains.

Psychologically it’s a tough way to trade – I’m always left feeling like I’ve ‘lost out’ – even when I’ve taken a healthy profit.

Combining trailing stops with profit targets

The problem with the trailing stop loss is that he’s a relentless optimist. He sits on your shoulder whispering to you that this trend ‘will run and run’ …. And the truth is that markets just aren’t that exciting most of the time.

Most of the time they move within their fixed ranges, and we need to content ourselves with a modest profit (heck, with ANY profit) on our trades.

For that reason, I’ll always combine my trailing stop loss with an achievable profit target – we have to take profits at the point where we think: ‘that’s enough, I’m happy with that profit.’ If this target is too modest, then we’re not taking advantage of our trailing stop’s benefits. But if it’s too far out, then the pain of giving up the Lamborghini becomes too much to bear.

(In my trade above, the price got around 20 points from my profit target before that pullback that took me out.)

As with all trading, it’s about finding a balance between snatching those profits off the table … or risking giving them back … and between finding what makes the most money … and what suits your personality.

I reckon it’s stuff I still need to work on …

And then I’ve just got to deal with my family moaning at me about the car I’ve booked for the holiday …!

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