Adding a trailing stop

A trailing stop is a stop order which adapts to the current market price. In the case of a new long position it is initially set at a fixed percentage below the entry price. If the market price rises, the trailing stop price rises proportionately, but if the price falls, the trailing stop price doesn't change (Figure 3.15A).

Figure 3.15A: The principle of a trailing stop. Chart example from British pound/US dollar (FOREX), 30 minute bars, September 2008. Chart from TradeStation 8.

Figure 3.15A: The principle of a trailing stop. Chart example from British pound/US dollar (FOREX), 30 minute bars, September 2008. Chart from TradeStation 8.

The trailing stop for short positions works analogously. This technique allows you to set a limit on the maximum possible loss without setting a limit on the maximum possible gain. Next we add such a trailing stop to our existing trading system. While looking for an appropriate trailing stop distance, we keep our initial risk stop loss of 0.3% in place. Whereas this initial risk stop is responsible for keeping the biggest losses under control, as outlined in the previous section, the now added trailing stop aims at keeping some more profit without losing it again.

If you add such a trailing stop and vary its distance from 0.01% up to 1.5% in steps of 0.01% you can plot the ratio of NP/DD as a function of the trailing stop distance (Figure 3.15B). Similar to the risk stop loss, tiny trailing stops cut the profits too much, since they don't give the trades enough room to develop. In particular, all trailing stop values below 0.2% lead to a disaster. However from 0.2 to 0.5% the results increase steadily and between 0.5% and 1% you find a broad region of trailing stops which increase the system's NP/DD ratio. If you set the trailing stops even wider then the ratio converges to the NP/DD ratio of the trading system without an added trailing stop. The stop distance becomes so big that fewer and fewer trades are affected by it.

Figure 3.15B: Ratio of total net profit/maximum intraday drawdown as a function of the distance of an added trailing stop. Risk stop loss of 0.3% kept in place. LUXOR system tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. SLOW=44, FAST=1. Including $30 S+C per RT.

Figure 3.15B: Ratio of total net profit/maximum intraday drawdown as a function of the distance of an added trailing stop. Risk stop loss of 0.3% kept in place. LUXOR system tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. SLOW=44, FAST=1. Including $30 S+C per RT.

It is worth mentioning that the NP/DD ratio (Figure 3.15B) is quite steady. Between 0.5% and 1% you find a broad region of values which lead to similar results. This increases the probability that the performed tests have a high predictive power for real trading. The trading figures (Table 3.4, on page 82, third column) reveal that a trailing stop of 0.8% (in the middle of the profitable area) leads to improvements, especially regarding profitability. The total net profit can be increased by the inserted trailing stop from $116,209 to $126,772 by nearly 10%. The average profit per trade increases by about the same percentage from $113 to $122. The risk figures are also slightly improved by the added trailing stop. The maximum drawdown of the trading system is further reduced from $11,266 to $10,292 and the percentage of time in the market is also now slightly lower (69.98%, compared to 73.56% before).

With the two types of stops in place we will now check if inserting profit targets will further improve the trading system.

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