Introduction
In our previous article, we presented diverse types of filters, which work as additional rules. We also showed how to incorporate these filters into a trading strategy so that they can help improve its performance.
In this educational article, the fourth section of the series dedicated to developing a trading strategy, we will discuss the profit management.
Profit Management
Profit management is an aspect of risk management that characterizes by its high level of complexity. The difficulty lies in that profit management seeks to preserve the profits obtained during the trade and also to prevent a premature exit from a market that still moves in a trend not over yet.
There are two available methods with which the trading strategist may manage the profits realized in an opened position. These are the trailing stop and the profit target order.
Trailing Stop
This type of order is dynamic. It moves only in the same direction of the position as it moves in the direction of the trend. In other words, a trailing stop will move upward in a buy positioning and downward in a sell trade.
Another characteristic of the trailing stop is that it steadily advances during the life of the trade. It will never retrace when the price develops a movement against the trade’s direction.
The trailing stop has two components, which are detailed as follows:
- Trailing stop: corresponds to the number of pips in which the stop loss order will move once the price moves in the trade direction. For example, if an order has set a 40-pip stop-loss, and the price advances 30 pips in favor of the trend, the new stop-loss will shift to 10 pips below the opening price. In general, there are several ways to establish a trailing stop: by fixed pip variation and by volatility using the Average True Range (ATR) indicator, or using SAR (Stop and reverse) stops.
- Step: this corresponds to the variation in pips that the dynamic stop will move behind the price when it has been activated.
Profit Target Order
The second mechanism to manage profits is by using a profit target order. This type of order is conditioned to the prince advance to a predetermined level. Likewise, compared with the trailing stop case, this order is not affected by the price decrease. However, its activation is subjected to the price reaching a specific level.
A profit target order can be set using a specific number of pips, by a multiple of the Average True Range (ATR), a percentage of price increase ( or decrease), specific levels of resistance or support, or a specific dollar gain.
Using the Trailing Stop in a Trading Strategy
This example illustrates the impact of using a trailing stop with a two moving averages crossover strategy, corresponding to LWMA(5) and SMA(55) periods using the EURUSD pair.
We have evaluated the performance of a 40-pip trailing stop with a variable step from 1 to 15 pips. The results are as follows.
In the table above, we distinguish the impact on drawdown reduction with respect to the base scenario, after the incorporation of a trailing stop rule to the MA crossover strategy. The base case, on which the exit rule is the MA cross in the opposite direction to the opening of the position, exhibits a 22.66% drawdown. However, the addition of trailing stops led to a reduced 10.44% drawdown and a net profit of -525.88 (USD).
Each trailing stop step variation scenario, including the base exit scenario of the trading strategy, is shown in the following figure.
Finally, we observe that a 7-pip step provides the lowest losses. We also highlight that as the step increases, the drawdown also increases, confirming the growing losses.
Conclusions
The application of Profit Management represents a significant challenge for the developer of the trading strategy. This complexity arises due to a wide variety of combinations that can be used to ensure the strategy’s gains as each trade moves in the trend direction.
In this context, as we have seen, the parameter setting to be considered, the trailing stop, profit target orders, or its combination, should be carefully evaluated before applying them to the trading strategy, to ensure the optimal settings.
In the next educational article, we will present the fifth and last part of the series dedicated to developing trading strategies that will explain the position sizing process.
Suggested Readings
- Jaekle, U., Tomasini, E.; Trading Systems: A New Approach to System Development and Portfolio Optimisation; Harriman House Ltd.; 1st Edition (2009).
- Pardo, R.; The Evaluation and Optimization of Trading Strategies; John Wiley & Sons; 2nd Edition (2008).
