Shaun Downey is a technical analyst with CQG in London and a contributor for SFO Magazine. Shawn has been in the financial business since 1979 and has held a variety of trading and head of trading positions for firms including Rudolf Wolff, Fulton Prebon and AFP. If you enjoy this post on how to prevent early exits, please click here for a complimentary subscription to SFO Magazine.
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A common practice when using trailing stops, (beyond money management techniques) is to use popular indicators such as the parabolic, ADX, moving averages or volatility stop.
While these methods do have merits, a recurrent flaw is their inability to prevent a premature trade exit when a market's corrective phase begins The same thing can occur when traders rely on calculations of a prior range to achieve a more dynamic type of trailing stop.
USE SWING POINTS
My preferred method to tackle this situation is to use swing patterns that are manipulated in order to prevent exits being triggered when the corrective phase is simply a byproduct of low-range or relative inactivity.
A swing point is defined by the third bar (of a consecutive set of five bars) on any time frame chart. The actual swing point can be either the high or low of that bar.
That swing point value will be valid until the next occurrence. Years of extensive testing reveals that breaking, on a closing basis, below the swing low (if in an uptrend) is statistically the most robust exit method.
However, there are flaws. The stop may be too far away for comfort. This five-bar pattern is by not a magic formula, but it can be manipulated depending on the asset class or time frame chart being used.
QUIET MARKETS
On very short-term charts, periods of relatively low activity also can cause a premature trade exit. This is especially prevalent with the extension of trading hours on futures and has been a perennial problem in spot foreign exchange markets due to their 24-hour nature.
CALCULATE AVERAGE RANGE
Any strategy that is active around the globe risks being stopped out during the Asian trading session, where periods of inactivity are at their greatest. Calculate the average range of each swing pattern to avoid the problem. In order for the swing pattern to be valid, it must be at least 20% above that average range over the last 1,000 bars.
This ratio can be adjusted based on the markets being traded but rarely moves beyond 100%.
SWINGS IN ACTION
A lot of information can be obtained by analyzing swing patterns. They can be used to qualify breakouts and for trailing stops. A breakout is signaled if the swing pattern levels cross over each other after a period of sideways movement.
See the example of a swing crossover (red lines) on Figure 1.
The crossover shows a lack of reaction to the new trend, which in Figure 1 reveals price being below the swings. It is a bearish signal. Finally, the re-definition of data to include only the most active part of the trading day on a five-minute chart allows analysis of how many trends can occur within one day and the limit of continuous swing patterns within that period.
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Best of luck with your exit strategies,
SFO Magazine
