The momentum-based trailing stop
Choosing to close a position is often more difficult than choosing to open one.
The decision to open a position can often be made for you – when some moving averages cross, when a breakout occurs, or when there is an economic or company announcement. In an unsuccessful trade, your stop loss will take care of the exit. However, profitable trades can be more difficult – should you take your profits, or hold the position in case the market keeps moving in your favour?
One commonly recommended exit strategy is setting a trailing stop. A trailing stop functions like a regular stop in the sense that it automatically closes your trade should the market trade through the level you set. Unlike a regular stop, though, a trailing stop will follow the market as it moves in your favour, always remaining the same distance from the most favourable price. In this way, it functions as both a risk management and a profit taking tool – protecting you from the risk that the market will turn, and protecting your profits if you have already made some gains before the market turns.
However, if you choose to use a trailing stop to exit your trade, there are still issues with where to place it. After all, you don’t want to be stopped out in the minor fluctuations that occur in any trend.
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One trailing stop strategy is the momentum-based trailing stop.
The momentum-based trailing stop involves placing a wide trailing stop (at 50-100% of the average price range of the asset), and then scaling it in once certain technical or fundamental criteria have been met.
From a technical perspective, you could wait for a breakout of a certain level. From a fundamental perspective, you could wait for the confirmation of an expected announcement. Both a fundamental and a technical consideration is waiting for an asset to reach overbought or oversold levels (using the Relative Strength Index in conjunction with being informed about your market can help with this).
This requires patience, as you may need to wait for the first quarter of the move before scaling in the stop. Then, once the technical and/or fundamental criteria have been met, you can place a tight stop (around 10-20% of the average price range of the asset).
As technical/fundamental milestones often add strength to a movement, this is the point when large jumps are more probable, and stgiations from the trend are less likely. As a result, a trader who incorporates a momentum-based trailing stop into his strategy may be able to take greater advantage of strong price movements than those who set a tight stop from the outset and risk being shut out of the trade before the market moves in their favour.
Disclaimer
This article was written by Jacqueline Pretty –IG Markets.
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