Why trend followers use trailing stops
Most trend-following models rely solely on trailing stops to exit positions. It may seem a little odd that you never attempt to take profits, but this is nevertheless a key component for the trading models that the USD 300 billion CTA business is employing.
With trend-following positions, you will want to stay with the trade for as long as possible. It's the long-lasting positions that pay for the party and if you exit too early, you risk getting left behind in the dust. There is nothing wrong with trading strategies which rely on taking a certain amount of profit, exiting on strength. There are many valid trading approaches that work that way. But trend following is not one of them.
Let's take a look at the coffee market as an example. This market has been falling for quite some time. Most trend followers are likely to be in the short positions since at least May of this year.
Back-adjusted coffee futures continuation
Source: CSI Data
The coffee chart shows a classic trend entry, based on a breakout in the direction of the trend which in this case was negative. For this trade, you were in a profit very fast and it might have been tempting to take profit after just a few days. The short-entry price (back-adjusted), was around 137 for this trend model and just a week later you were down to 130. Five percent in a week is not bad, but exiting there would still have gone against the principles of trend following.
What you should notice on the chart above is the little dotted line. Each dot shows a stop point. For a short position, this stop will never move up, only down. My preference is to base stops on daily data only, which is not the case for everyone. This means that the price needs to close beyond the stop to trigger a position closing the following day.
Any day that a position closes at a new extreme in your favour, you move the stop. So as your profits grow, your stop moves. Down for shorts, up for longs.
This method guarantees that you will never exit on the best possible prices. Not possible. You will always lose money at the end, just before the position is closed. That loss is the price of admission for participating in trends. We're not looking to trade in extremes here, just to participate in lasting trends.
Most trading software only provides trailing stop based on intraday data, not on daily closes. That means that if you would like to use daily, you need to do a manual run. Every day, you need to look over your positions and see if any of them violated the stop at the close.
The coffee market since May provides a classic example of how trend following can work. Photo: Shutterstock
Why not just use intraday trailing stops? Some do that as well. I prefer not to, due to the high frequency of false violations. Look again at the same coffee chart above. On July 17, about half way through this amazing trend, the prices spiked far beyond the stop. An intraday trailer would have taken out the position there. The same day, the price fell back down again, and the trend kept going. Getting stopped out in these instances is extremely frustrating and it happens more often than one might think.
How do you know whether to use daily or intraday trailing stops? My advice is to do proper simulations. If you do proper modelling of your strategies, you'll learn your probabilities. This is the huge advantage that systematic traders have over discretionary ones. Knowing the odds.
If you make a discretionary trading decision, you're likely to make it based on recent experiences. If you're able to simulate your strategy and calculate probabilities over time, you'll be able to analyse scientifically, if your recent experiences reflect reality in the long run or not.
If you don't have intraday stops, you risk taking a bigger hit once in a while when the prices really make very big moves in a day. What you need to figure out is of course what's more expensive in the long run. To take a bigger hit from those outlier moves when they occur, or to miss the profits from being stopped out too early many times. In my own experience, those bigger moves are very rare and the cost is worth it.
Back-adjusted Nasdaq futures continuation
Source: CSI Data
The Nasdaq chart above shows a similar situation, on the long side. If you took that entry, you may have been tempted to close out your profits many times. When the price dipped in October, the stop point was penetrated intraday but never on a closing basis. If you took the stop, you would probably beat yourself up later.
To be fair, let's also show an example of when things go wrong with this approach. The most extreme situation in my experience was the margin shock in heating oil in 2011. This was a very painful trade in which most of the CTA field participated. Just after fresh long-entry signals, there was a massive increase in margin requirements for heating oil. That forced many larger funds to shut down positions fast, to lower their margin to equity ration, avoiding both margin calls and compliance issues.
This was a very painful trade that sticks in the memory, but also an extremely unusual one.
Back-adjusted heating oil futures continuation
Source: CSI Data
This of course still leave the question about how to set the distance to the top. Well, that'll be the topic of another post.
— Edited by Martin O'Rourke
Andreas F. Clenow is a hedge fund manager and principal at ACIES Asset Management. He is also the author of the best-selling book Following the Trend (Wiley 2012).