Trailing Exits

As important as cutting your losses is the concept of, ‘letting your profits run.’ You need to ensure that the profits you achieve outweigh all the small losses incurred. Never think that only professional traders are profitable in well over half of their trades because you will find many of them aren’t. How can that be?

It is the average loss and average profit that is the key. The potentially many losses that are taken are relatively small compared to the larger, but fewer profits that are made.

The term ‘trailing exit’ refers to your exit level trailing the share price by a set amount as the share price moves upwards. If the share price reverses, the trailing exit locks in and is in a position to ‘catch’ the share price should it fall down to the exit level, and therefore trigger an exit. If this happens, take it as a signal to close the position.

If the share price does not move to the exit but continues on higher, the trailing exit also continues to move higher and follow underneath the price.

It is imperative that there are steps in place to ensure you maximise your profits, but do not take them too early. This is why the notion of ‘you’ll never go broke taking a profit’ is wrong. In fact, this is exactly the reason why a lot of traders do go broke. They take their profits too early and don’t let them run so that they can sufficiently offset their previous losses.

Successful traders want to give a share price room to move, in order to see how far it can take them, whereas most people are too quick to grab a profit in fear of losing it all.

No one can pick the high in a share price until it has happened, so don’t try to. If you have ever exited a company at its high, then congratulations. But I am sorry, it had nothing to do with your trading skill — it was all luck! You should always want to see the high in a share price achieved before you think about exiting. The real key about profits is seeing how far they go before accepting that the run is over.

Obviously, you need to strike a balance between not taking your profit too quickly and not giving it all back either. How do you do this?

There are a number of ways to calculate trailing exits. Again, the method you choose is not the important decision to be made, rather, it is paramount to have a method in place to ensure you let your profits run. In a similar fashion to calculating a stop loss, popular methods used for trailing exits are based on percentage retracement, technical analysis and volatility.

Example 1: (Percentage Retracement)

A simple method of creating a trailing exit is to consider a percentage retracement from a stock’s previous high price. However, the percentage retracement can either be calculated from the share price or in terms of the unrealised profit (taking into consideration your entry price). Similar to the volatility method, the percentage you select should be determined according to the timeframe in which you consider trends.

If you were using a percentage retracement of your unrealised profit, you may consider using a percentage anywhere from 20 to 50 per cent. Those who consider longer-term trends would likely consider a number closer to 50 per cent. Many would think that 50 per cent is a lot to give back, but the strength of this approach is in giving the security ample opportunity to develop into a significant long-term trend, which can, in many cases, take time to develop.

Let’s say you purchased 1,600 XYZ shares at $2.50 = $4,000
Share price achieves a high of $4

Using a 33 per cent retracement of the unrealised profit:

= $4 – [33 per cent of (high – entry)]
= $4 – [33 per cent of ($4 – $2.50)]
= $4 – $0.50
= $3.50

I know that the price in the chart moves beyond $4.00 however I have selected that price for ease of calculation in the example. On a regular basis, you should check your exit price and adjust accordingly. As the price moved above $4.00, you would be raising your exit level based on the formula above.

If you were using a percentage retracement from the share price high, you may consider using a percentage anywhere from between 6 to 12 per cent. This approach does not consider your entry price. Again, those who consider longer-term trends may use a number closer to 12 per cent, and those who consider short-term trends, close to 6 per cent.

Let’s say you purchased 1,600 XYZ shares at $2.50 = $4,000
Share price achieves a high of $4

Using an 10 per cent retracement of the share price:

= $4 – (10 per cent of $4)
= $4 – $0.40
= $3.60

This method is illustrated in the chart below. Notice the solid black line trailing the share price by a set margin … this margin is 10% of the present high price. You will note that the trailing exit level never lowers even though the price may fall over a short period of time. It only moves higher when the price does. Importantly, the trailing exit is NEVER lowered.

This is an important factor in using a trailing exit – it only increases and locks in profit as the share price increases.

Both methods are very simple and mechanical but effective. Again, those people who are only just beginning to trade would be wise to use them because there is little subjectivity involved in their calculation.

Example 2: (Volatility)

Using the ATR method results in an exit trailing under the share price by a multiple of the stock’s ATR. In essence it is identical to the percentage method above except the margin is based on ATR. Similar to the ATR-based stop loss, you would decide to exit if the share price moved a number of average days against you from the high. Such movement would indicate that the share price is starting to move against you.

Let’s say you purchased 3,200 XYZ shares at $1.25 = $4,000
ATR (15) = 7¢

An example of this method can be seen in the chart below where a trailing ATR stop has been placed on the chart and where the margin is 3.5 multiplied by the ATR. In other words, at any point on the chart, the exit price is the present high price (since the trade was entered) minus the present ATR x 3.5.

Example 3: (Technical)

Using a technical trailing exit requires the analysis of the stock’s chart and a determination made regarding at what stage the security has shown clear signs of changing direction, rather than a small retracement associated with a trend. There are many instances where you may employ a technical exit.

For example, a share price crossing and trading below a moving average, a security breaking through a previous support level, or a significant candlestick or formation appearing on the chart.

In the chart below, the same stock can be seen with a 40-day simple moving average – when it crossed and stays below the moving average, this signals a potential change in the trend and a suitable exit point.

Technical exits are a very effective form of determining exit points, simply because you are constantly analysing the share price’s behaviour. As soon as the share price shows you that there is a change in likely direction, then a signal is generated to exit.

You can see how employing technical stops requires great discipline and experience to be executed well, otherwise it is too easy for emotion and ‘spur of the moment’ thoughts to become a part of the decision process. The professionals who use technical stops are unemotional, and exercise great discipline when making their decisions.

An important side note is when precisely to exit. Do you exit the moment/the day that the price trades below your trailing exit (even if it closes back above) or do you only exit when the price trades below AND then closes below your trailing exit. There is no right answer to this question – just pick one and stick with it.