5. Trading To Avoid The Disposition Effect

An effective method is to let the market take you out of a position, instead of having a fixed price target before entering the trade. This naturally allows for winning positions to keep on accruing profits as the market trends.

The problem with doing this, however, is that traders do not know when to exit.

This creates two problems: the first of which is figuring out when to exit a trade, and the second, figuring out how to calculate reward/risk ratios.

The first problem is easily solved by using a trailing stop. This is simply a stop loss that moves with the market, which means that if you are long and the market moves higher, the stop loss moves higher as well.

How far away to set the trailing stop is up to the individual trader, but needs to be aligned with your overall risk management strategy.

That is, if you are comfortable risking 1% of your capital on a position when using a normal (non-trailing) stop loss, your trailing stops should also be set to a level that reflects the same amount of risk.

Using our initial AAPL example, where our hypothetical trader goes long the stock at $145, let’s consider what happens if he decides to set a trailing stop.

He first decides to set his trailing stop $2 below his entry point, which is $143.

In addition, he wants to manage his trailing stop manually (some brokers can do it automatically for you), and decides to do this by updating the stop loss level near the end of each trading day by subtracting $2 from the day’s high.

If the market is trading below the level of the new stop, he would exit the position, and if the market does not make new highs, the trailing stop remains the same as the previous day’s.

Here’s how it would look:

The trailing stop does exactly what it was designed to do, allowing our AAPL trader to let his winning position run higher as Apple moves up to form a short term high at $149.82 on 26 July.

As the stock turns down the next day, the trailing stop gets him out of the position with a profit of $2.82 a share (147.82 – 145).

He has successfully allowed a winning trade to run, and cut possible future losses short when the market turned against him.

Do note that there are more sophisticated methods of calculating trailing stops, a popular variant of which is the Average True Range (ATR) stop, which factors in market volatility into the calculation of the stop loss level.

(If you are interested in learning how to construct and use an ATR stop, we discuss how to do so in our course on how to create an effective trading plan, available for free!)

This can prove useful when entering positions during times of high market volatility, where a simple “$2 below entry” rule will not provide a position the space it needs.

Now, how do we calculate our reward/risk ratios when using trailing stops?

Since trailing stops leave us without predefined exit levels, we will have to make do with less precision. The “risk” part of the ratio is straightforward since we can just use our initial stop loss level; in the AAPL example above, that would be $143.

For the “reward” portion, we can refer to the previous high (or low for shorts) on the chart and use that level. For our hypothetical AAPL trade, that high would be $149.98, set on 15 July, giving us a reward/risk of (149.98 – 145) / (145 – 143) = 2.49.

It is important to understand that calculating the “reward” portion of the ratio in this manner works because we are deliberately trading with the trend.

Therefore, selecting previous highs in a market that is trending upwards represents a reasonable compromise, since it is probable that those highs will be surpassed in the near future.