The markets have rallied significantly since March, 2009 and many investors are looking for a way to protect their gains. Deciding when to exit a position is just as important (maybe even more important) as determining when to enter the position.
Some form of a trailing stop exit is often appropriate for trend-following strategies. Here are three forms of the trailing stop you could use-
1) Simple Percentage Trailing Stop
This technique maintains a stop-loss order (or a mental stop-loss order) at a fixed percentage below the market price. For a mutual fund, you would use a mental stop and only consider end of day prices. For a longer term strategy you might even consider using only end of week prices. The stop-loss is adjusted continuously after each trading period if the price goes higher, but is not changes when the price goes lower. Here is a simple example using a mutual fund (end of day prices) and a 10% trailing stop.
Close Trailing Stop
50 45 (BUY)
47 (SELL) because fund closes below trailing stop of 47.70
2) Parabolic Trailing Stop– also known as Parabolic SAR (stop and reversal)
The parabolic trailing stop can be used to take both long and short positions on the same security, but I will only consider long positions here. The trailing stop-loss is set below the entry point on the first day of the long position and rises according to a formula as the price rises.
The parabolic trailing stop is different from the simple traditional trailing stop because the parabolic stop continues to rise every day even when the price holds steady or drops. Eventually the price and the parabolic stop will meet which triggers the exit.
The parabolic trailing stop should normally be used only for securities that exhibit a
persistent trend which can be measured by using a runs test which I have described in a previous post. The concept behind a parabolic stop is that your money should always be working for you. Time is money. Unless an investment can continue to generate more profits over time, it should be liquidated.
The formulas used to compute parabolic stops are somewhat complex, but are available in most trading analysis (Amibroker, Metastock etc) and charting programs. Charts using Parabolic SAR are available for free on stockcharts.com.
3) Chandelier Trailing Stop
The Chandelier stop is a trailing stop that varies depending on the price volatility of the security as measured by Average True Range and the highest high or highest close of the trade. It used primarily for stocks, but not for mutual funds since they do not report high-low daily prices.
Chandelier Trailing Stop Price= HC – ATRMultiplier * ATR(Length)
Where HC is the highest close, ATR is the average true range function available in trading analysis and technical charting packages. It is based on trading trading ranges smoothed by an N-day exponential moving average.
-Length is the number of days used in the ATR calculation. A default value of 10 days is often used.
-ATRMultiplier: Default is usually 3.0, but can vary from 2.5 to 4.0.