How to manage trades when they get close to your target
The 1:1 trailing stop rule
I’d like to start by sharing the interview I did last night with Maggie Lake on Realvision’s Daily Briefing. In the video I discuss global liquidity, the China reopening, vulnerabilities in the government bond market, and the BoJ. You can find the interview on the Realvision platform, Youtube, or on Spotify. Do follow me on Twitter if you haven’t already, as that is where I provide real time trade updates and market commentary in between blog posts.
How many times has the market gotten close to your take profit limit order, and then reversed and caused you to give up more gains than you would have liked? Were those extra few points worth it? In my two decade-plus career, it’s happened plenty of times, where I’ve given up some or all of the profit on a trade just because my take profit order was missed by a hair while I was sleeping.
There is an inherent flaw when it comes to risk managing trades that have a defined stop loss and take profit target. At the point of entry, the potential reward if the target is hit is usually greater than the pnl risked if the stop loss is triggered. However, as the market moves toward the target after the trade has been entered, the risk/reward ratio becomes heavily skewed towards the “risk” side if the original stop loss and target remain in place.
There was one night back when I was working as an FX trader at a bank and I was running a long usd/jpy position that was 120 pips in the money. I had only risked 40 pips on the trade, so this was a rather good result so far. I had a take profit sell order loaded at 123.98, about 30 pips above the current market before I went to sleep. I didn’t think about moving my stop, which was at its original level of around 122.10
The thing one should know about usd/jpy is that big round numbers tend to attract large option barrier interest, which sometimes coincides with exporter selling interest. Usd/jpy will often stall and reverse at big round numbers due to these large limit orders sitting at or ahead of those levels.
I woke up the next morning and saw that my downside stop had been triggered. The 120 pip paper gain had turned into a 40 pip loss while I was sleeping due to a late session selloff in US equities. When I saw the overnight high in usd/jpy, my heart sank. 123.95. I missed my take profit by three pips!
After this happened enough times, I realized I needed a rule-based strategy that would mitigate this problem. I developed a rule that would force me to aggressively trail my stop closer to the market once the trade gets close to my target. How close to the market? Enough to make the reward/risk ratio 1:1 or better.
The 1:1 trailing stop rule, explained:
Let’s say you buy stock XYZ at 100, with a stop at 90 and target of 150. You’re risking $10 to make $50 - a healthy 5:1 reward to risk ratio. The trade goes spectacularly and after a month, price reaches 140. If your stop is still at 90, you are now risking $50 of downside pnl just to make $10 if you reach your target.
This is where the 1:1 trailing stop rule comes in. If price reaches 140, I’d trail the stop to 130 so that I’m risking only $10 to make $10. At 148, the stop trails to 146. As price reaches the target, a trader needs to get a lot more active in monitoring the high water mark of the trade and adjusting the stop accordingly.
You don’t need to wait for the market to get close to your take profit level to activate the 1:1 trailing stop rule. This rule can be activated as soon as the market reaches the halfway mark towards your target. This would move your stop to breakeven.
There are some traders who don’t use take profit orders, and instead leave positions open-ended with a trailing stop. That is perfectly fine and this rule doesn’t apply to them.
As with any risk management strategy, there are tradeoffs. The 1:1 trailing stop rule will decrease the volatility of your returns, but the downside is that you occasionally will get whipsawed by the market. You also won’t achieve the satisfaction of having the market hit your take profit order as much. But then again, trading is about making more money than you lose, not about satisfaction ;)
Disclaimer:
The content of this blog is provided for informational and educational purposes only and should not be construed as professional financial advice, investment recommendations, or a solicitation to buy or sell any securities or instruments.
The author of this blog is not a registered investment advisor, financial planner, or tax professional. The information presented on this blog is based on personal research and experience, and should not be considered as personalized investment advice. Any investment or trading decisions you make based on the content of this blog are at your own risk.
Past performance is not indicative of future results. All investments carry the risk of loss, and there is no guarantee that any trade or strategy discussed in this blog will be profitable or suitable for your specific situation. The author of this blog disclaims any and all liability relating to any actions taken or not taken based on the content of this blog. The author of this blog is not responsible for any losses, damages, or liabilities that may arise from the use or misuse of the information provided.