Trailing Stops in Forex

Adam Lemon

I ran a little testing over the weekend over a Forex trend trading strategy I like to use.

The entries are quite simple – you enter after a pullback when the price starts to move with some strength back in the direction of the trend. In other words, “buy the dips”, and there is nothing revolutionary about that. I am confident that this strategy has a positive expectancy in the major currency pairs and crosses (USD, Euro and Yen). After testing it over a 16-year period encompassing several thousand trades, it has a positive expectancy at all reward to risk targets of 1 to 1 and above. So far, so good. What I was testing was not the entry strategy, but the exit strategy. Where to take profit?

Exit strategies are often overlooked. That is a shame, as it is possible to use a good entry strategy with a positive expectancy, and still lose money over time, if you do not approach the exits right. One of the most popular exit strategies to use is a trailing stop. There are a few different types. What they all have in common is that they raise the stop loss price as the trade progresses favorably. Forex Trading

I was testing a method whereby the stop loss is raised as the historical 2-day low price reaches a higher level than the original stop. I thought that this might work well in Forex, where the price often takes a long time to get going. Interestingly, despite testing it on over 100 randomly selected trades, it came out worse than using even conservative fixed profit targets. I had to think about it for a while before I came up with an answer as to why this should be the case.

Almost any good mechanical trend trading strategy over the long-term will produce significant positive expectancy only with reward to risk ratios greater than 2 or perhaps 3 to 1. The huge majority of trend trades, probably at least 70% of them, will not even reach 2 to 1. As any trailing stop method will have to give back a serious proportion of floating profit, it means that the large majority of trades are going to have a negative expectancy. This might be offset by a few huge winners, but consider that anything but the most spectacularly fast winners will probably be stopped out well before reaching any reward to risk ratios greater than 5 to 1.

What all this means, is that mechanical trailing stops applied to mechanical Forex trading systems, will almost certainly produce inferior returns compared to taking profits at set targets based upon reward to risk ratios of 2 or higher.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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