Why is it so?
If you’re of a certain age, the opening line will have a familiar ring. It was the catchline for an offbeat science professor — Julius Sumner Miller.
The professor was a regular on ABC television during the 1960s, 70s and 80s. His quirky experiments and enthusiasm for science made him a hit with generations of Aussie kids.
Sumner Miller’s fame hit new heights in the mid-80s.
A series of ads for Cadbury chocolate made him a household name. The professor would exhibit a scientific principle before describing the goodness of the product.
I still recall the ads today…
My favourite was when he dropped a piece of burning paper into a milk bottle. He then put a hard-boiled egg on the rim. And within seconds, the egg was sucked into the bottle.
‘Atmospheric pressure does the work!’ exclaimed the professor.
But behind all the fun was a serious question: ‘Why is it so?’
You see, Sumner Miller didn’t want viewers to just sit back and accept reality…
He wanted them to understand.
Have a read of this:
‘Question on Quant Trader’s trailing stops: Most appear to be around 30%. But some are much less — for example 12%. Can you give any insights to how stops are decided?’
This is an excerpt from an email a member called Greg sent me. It raises a question about the system’s trailing stop strategy. Understanding this could help you stay in your best trades for longer.
Most people join Quant Trader for the buy and sell signals.
And I understand that…
The system’s job is to search through 2,000-plus stocks for opportunities. It identifies which stocks to buy, and it calculates a unique exit point for each trade.
But that’s not all the service does…
I also want you to gain the skills to confidently trade for yourself. That’s what these weekly updates are all about — passing my trading experience on to you.
I told you about fixed percentage stops last week. This is a great strategy for maximising upside and providing an exit point. It’s also a method you can readily apply yourself.
This week’s update takes trailing stops to another level. I’m going to explain how Quant Trader uses volatility in the calculation. This will give you a new perspective on the exit strategy.
Behind the curtain
As you know, stocks trade within a daily price range. For example, today’s range may be $4.00–4.10, and tomorrow’s could be $4.04–4.12. The range is usually different each day.
Now, a single range doesn’t tell you much — it’s just a high and a low.
But a series of ranges is different…
Quant Trader calculates an average trading range (ATR) for each stock. This provides a guide to share price volatility. The system then uses the ATR to set the trailing stop.
Have a look at this:
The graph shows a trade in Smartgroup Corporation Ltd [ASX:SIQ]. Quant Trader’s entry and exit points were $2.54 and $6.12 respectively.
Let me explain what’s going on…
A key point for any trailing stop is the share price high. This is the level from which you calculate the exit price. This point is fixed until the shares reach a new high.
So if a stock hits a peak of $5, the trailing stop will ‘hang’ below this point. It will continue to do that until the share price makes a new high above $5.
I’ve marked two sets of share price highs on the chart. There are of course many more highs within this trade — I’m just highlighting two for this example.
Now, the first figure on the graph is 39%. This is the distance between the share price high and the trailing stop.
Just to the right, you’ll see 27% — the gap between the high and the stop is smaller. And remember, the trailing stop calculation for both exits use the same share price high.
So why is the gap narrowing?
Well, it all comes down volatility…
Have a close look at the share price in the lead-up to the high. There are several big trading ranges. This includes the large gap as the shares surge upwards.
Quant Trader responds to greater volatility by widening the stop. The purpose of this is to reduce the odds of the larger trading ranges triggering an exit.
You could think of it like a jetliner flying into turbulence. The pilots will often climb the aircraft to a higher altitude to avoid the bumpy ride.
The opposite happens when volatility falls. Rather than giving a stock extra room to move, the trailing stop will come in closer. The aim is to minimise your potential downside.
Have another look at the chart:
I want you to focus on the gap of 27%.
Notice how the trading ranges get smaller in the weeks prior. This is the catalyst for tightening the trailing stop. The calmer conditions render the wider stop unnecessary.
You’ll see another example near the end of the trade.
Again, volatility rises leading into a high. The share price then begins to stabilise and the trading ranges narrow. This causes the trailing stop to move in closer.
If you’re wondering, Quant Trader calculates the ATR over the past 30 trading days.
The system then multiplies the ATR by 10 to generate the trailing stop’s width. It’s then just a matter of deducting the width from the share price high.
One size doesn’t fit all
So just how flexible was SIQ’s trailing stop?
Here are a few stats…
The widest gap between the share price and trailing stop was 43%.
The narrowest point was 21%.
And the average was 32%.
Now here’s the thing: These figures will be different for every trade. Many stocks will be considerably less volatile, while others will be like SIQ.
And this is the beauty of the approach.
By using a stock’s ATR to calculate the trailing stop, you create a unique exit for each trade.
It’s a bit like comparing a tailored suit to one off the rack.
The ready-made suit will probably do a fine job.
But a tailor’s suit may be that little bit better.
Check this out:
This is the same trade in SIQ you saw earlier.
But this time it doesn’t use Quant Trader’s ATR exit method. Instead, it has a fixed 25% trailing stop. The result is an earlier exit during a relatively large correction.
Let’s try this again using a 30% trailing stop:
The wider exit stop doesn’t trigger during the big correction. But it gives back more profit than the ATR method when the trade ends.
While a fixed trailing stop is a great strategy, it doesn’t get the best results on this occasion.
So does this mean you should only consider the ATR method?
Not at all.
I believe the fixed percentage exit is an excellent strategy for most people.
Unlike the ATR approach, a fixed percentage is quick to calculate. You also don’t need a pile of data and a spreadsheet. An everyday calculator will do the trick.
Sure, it’s not as tailored as an ATR exit.
But the fixed percentage method achieves the same purpose: It lets your profits run, and it gets you out when the trend turns.
And best of all…
You have the knowhow to do the calculations yourself.
Until next week,
Editor, Quant Trader