So I have been home sick for about a week now with a nasty sinus infection (and I think that has shown in the generally declining quality of my morning update emails and tweets). I had in mind a peaceful trading day from my couch with nice tame stocks, but when AAPL drove 10 points off the open, pulled back about a third of the day’s range in a two-legged pullback, and had a little flush below VWAP, I had an opportunity I couldn’t afford to pass up. (That combination of factors, by the way, is a repeatable high-probability pattern: strong opening drive on good volume (even better if there’s a gap opening), pullback less than half the day’s range (ideally in two legs), and then a flush to stop out people buying into the pullback with tight stops. We see this pattern several times a week, which is yet another use of the morning in-play list I tweet every day. Another lesson here is that even with incredible moves and volatility, simple technical patterns work.)

After that kind of opening drive, I was thinking gap closure could be on the menu for the day, and, in my wildest fantasies, I was thinking if we could hold above Friday’s low then there was a pretty good chance we’d rip through Friday’s high. I traded the stock a little bit, catching some moves on the tape, basically waiting for stops to be hit and buying after or into the flushes, had built up a little profit cushion and basically wanted to give the trade a chance without paying too much attention to it… that is, as the drugs for my sinus infection finally caught up with me. (Funny thing, Steve emailed me later in the afternoon noting that I had traded AAPL really well up until about 12:30, at which point it kind of looked like I wasn’t paying attention or something. I didn’t tell him that that was the point that the combination of antibiotics, corticosteriod nasal spray, multiple overdoses of cough syrup (bad idea, fyi), chamomile tea (far worse idea, btw) started to win and I had to take a nap. Oh well, now he knows. 🙂  I thought the best chance I could give this trade was to pull out a tool I haven’t used in quite a while: a mechanical trailing stop I built many years ago.

There are many forms and variations of trailing stops. The question they all seek to answer is simple, but important: what is the right balance between locking in profits and being willing to give back to let the trade flex on pullbacks? If your stop is too tight, you will be stopped out of moves early, leaving a lot of money on the table. If your stop is too deep, then you will give back more profits than you need to. Make either of these mistakes and you will not be profitable over a large sample size. There is no perfect answer, and what answers there are have to be examined over a large set of trades before you know that you have something that works. This is something I have literally spent years working on, and, in my experience, the “sweet spot” is fairly small. (Also worth noting that a good discretionary trader can outperform these types of stops, but that’s another topic for another blog post.)

Frankly, I never understood the fascination with having the kind of stop that many brokerage platforms offer that will simply trail a stop X cents from the current price. How do you know that X cents is correct? Where did you come up with the value for X anyway? Far better trailing stops can be done manually under previous swing or pivot points, and if this is combined with a read on market structure you can end up with something pretty powerful. (I usually trail two pivots back for starters.)  Trend lines, in my experience, are not a great answer because you often want to be buying flushes through uptrend lines, contrary to what is usually taught in most technical analysis books. This is a common place for people to put their stops, so, of course, the market goes there and does what it does.

The best mechanical trailing stops are those that automatically adjust to the volatility of the market. A wider stop is needed in a more volatile market, and the stop also needs to adjust if volatility conditions change while the trade is in progress. There are many ways to do this, and if you’re interested I would Google the following (in this order) and do a little reading: Chuck Lebeau Chandelier Stop, Welles Wilder Parabolic, Cynthia Kase DevStop. For an out-of-the-box solution, most software packages do offer some version of Wilder’s Parabolic system; this might be a good place to start though, with some work, most traders will be able to improve upon the original system. I have a trailing stop in my toolkit that I developed quite a few years ago and have used in many contexts. I have friends running a mid-sized CTA who use this on a daily/weekly time frame. I used it in a discretionary swing-trading context and I also traded it on a very active system that mechanically faded opening gaps and used this stop. (The system wasn’t very good but it made money because of this stop.) In fact, this trailing stop will scratch out decent profits on an entry such as a moving average crossover that is little better than random, so there is an actual, verifiable edge in this tool. Of course, a stop like this never gets you out at the exact high of the move. That is not the point, but the point is to say that when the stop point is reached, the probabilities and momentum have shifted enough to compromise the integrity of the trend. It may still go up, but the easy part of the trade is probably over (read: more often than not, over a large sample). Take a look at what happened with AAPL today:

In the chart above, you can see the stop level as a series of red dots under the price bars. This stop is slightly more complicated than most of the ones out there, but it is most similar to LeBeau’s Chandelier stop. All it needs is your approximate entry time to make its volatility calculations, and then it basically trails a stop based on this volatility measure from the highest point reached since trade entry. Note that the stop actually moves closer to the bars through the day because volatility is contracting. My final exit from the trade was the bar that cut the trailing level just after 2:00, which, in retrospect, was not a bad place to pull the plug unless you planned to hold overnight and through earnings.

If you don’t already have a tool like this, you might (or might not) find it a useful addition to your toolkit. A stop like this is not a panacea, but it can provide some structure and discipline to your exits from trending plays. Just for further reference, here is the stop applied to a few more charts from today. As you see, a mixed bag… but, over a large sample size, you will make money if you apply a well-built tool like this with consistency and discipline.