Trailing stops when you think a peak is near
Posted by Danny on July 23, 2013
As I described in my weekend post covering our key reversal levels, I like to use a trailing stop when daily momentum turns down after a sizable move in the market.
When a market has a fully bullish picture ( status = bull , weekly mom = up , mode = rally , daily mom = up), then it has usually staged a nice advance, which has to come to an end at some point. The first sign that the end may be near is when the daily momentum turns down. Last week that happened already for the Nasdaq and Nikkei, and yesterday the FTSE100 and crude oil also saw their daily momentum turn down.
That’s when I start using a trailing stop. It is not at all rare for the market to continue upwards for several bars after daily momentum turns down, or for the daily momentum to turn back up after a few days. Using a trailing stop will then pull in some additional profits.
Here is how it works:
When the daily momentum has turned down, then the trailing stop is to be kept just below the previous day’s low. Friday’s low for the Nasdaq was 3578.57, so yesterday I kept my stop at 3578.50. The Nasdaq stayed well above that level yesterday, so was not stopped out. The daily momentum remains down however, so for today I move my trailing stop to just below yesterday’s low, which was 3587.46. As you can see, another 10 points profit is locked in now.
Eventually one of two possible outcomes is going to happen: either we get stopped out when the market trades below the previous day’s low, or the daily momentum turns back up before our trailing stop gets hit. In the second case it means the bull run continues and then we don’t move the trailing stop to previous day’s low anymore (can just keep it where it was). Eventually the daily momentum will turn down again, and then we will start trailing our stop again.
Important note: these trailing stops are used intraday, not on a closing basis like for the key reversal levels themselves. So, as soon as Nasdaq falls below 3587.46 the stop is triggered, you don’t have to wait for a close below 3587.46.
Taking the example of crude oil (nearest futures CL), where the daily momentum has also turned down. For today we put a stop just below yesterday’s low, which was $106.48. This locks in a nice profit, as oil went into rally mode at $97.
This is about not letting a good profit go away, while still making the most of a good move.
That’s important because losses are going to happen from time to time. So, if you haven’t made the most out of the good trades, or if you let some good profits turn into losses, then at the end of the day the profits may be too small to compensate for the losses.
One reader asked whether this trailing stop can also be used for entering short positions.
The answer is yes. When daily momentum has turned down in an otherwise fully bullish picture, then you can use the same daily trailing stop to enter speculative short position. But it is important to gauge the potential of that trade. When a market turns down after a good move to the upside it will typically go on to test its daily key support level. This means we can estimate the potential of a short trade. In case of the Nasdaq, if it falls below our 3587.46 stop level today, then chances are that the daily key support level will get tested in the next days or weeks. The daily key for Nasdaq currently stands at 3511 (up from 3502 yesterday), so we see a potential further drop of 60 or 70 points if our sell stop gets hit. That’s not bad for a short trade. If entered short you would then keep a stop-loss on that trade just above yesterday’s high, which was 3601.92. This means you would be risking 14.46 points (3601.92 – 3587.46) with the potential to gain about 60 points. That’s a nice risk/reward ratio.
Sometimes the amount of points you risk will be higher than the potential move from a drop towards daily key level, and then it is not such an attractive short trade to make.
When to take profits on that short position? I usually close half of the position when it gets near the daily key support level, keeping the other half for a potential move below the daily key. If that happens the market goes into decline mode and I may be in for a much larger move to the downside.
This are more advanced strategies based on our key levels and momentum indications. I plan to put up a permanent page for it, explaining them into more detail and with some graphs to make it easier to grasp.
Estimating risk and reward for your trades is what a lot of traders fail to do. That is a bit like driving blind and hope that everything will go well. Our key reversal levels often give an easy way to calculate risk and reward, and that can be very helpful.