To be effective, then, a trailing stop must increase the number of winning
trades so that the resulting system’s slightly smaller winning trade size makes up
for its slightly greater largest single-trade losses. In the best of worlds, a trailing
stop can increase profits further because it shortens the trade length, which results
in more trading opportunities with a higher likelihood of success. But this will not
work at all times, because shortening the average trade length might demand a
longer maximum allowed trade length, to keep the average trade length within
desirable limits. As you can see, this is a complex matter and, depending on your
trading horizon and entry technique, it might be impossible to fit a trailing stop
into the equation.End of Event
Whatever chart pattern or indicators you’re using to enter a trade, some sort of
news or other fundamental event is usually behind the technical formation that
triggers the entry. Whenever we’re entering a trade, we need to be aware of this
event and ask ourselves at the end of the day exactly what that event was and if it’s
likely to play a role in the stock’s future development over the next several days.
Can you remember what type of fundamental news it was that made you buy and
sell today? Can you remember what it was yesterday or two days ago? Are those
reasons still valid, and is the market still talking about them? You probably can
remember these things and the reasons probably are still valid.
But can you remember what drove the market 10 or 15 days ago? Are those
factors still making the headlines? They probably aren’t, and most likely you can’t
remember what they were without looking in an old newspaper. Thus, a majority
of those reasons to be in a trade are no longer valid. The market has moved on to
discount other things, and so should you. In fact, I believe this is one of the most
underestimated reasons to exit a trade.
The difficulty with the end-of-event exit, however, is that it is very difficult
to measure and research. Most often, you have to implicitly assume the event is
over, based on other pieces of evidence the market gives you. For example, if you
measure how the market behaves one to several days after an entry signal, you
might find that after a certain number of days, the results, or the many different
paths the market can take, become more widespread or dispersed. Maybe a major-
ity of your trades still move in the right direction, but those that don’t start to stick
out more. This is an indication that other pieces of news have hit the market and
that the market now prefers to discount that news instead of whatever piece of
news was behind your trade.
As we all know by now, the more widespread the outcome, the more volatile
the market, and the more volatile the market, the riskier it is. The more widespread
the different outcomes, the higher the standard deviation in relation to the esti-
mated profit from the trades that are going your way. Sooner or later, there comes204 PART 3 Stops, Filters, and Exits