Ask Colin

Should I set my trailing stops to sell out on a 10% drop from the previous day’s closing price?

I am not sure how to really answer this one. I do not understand the logic of using an arbitrary stop of 10% below the last closing price. Does the logic of your trading plan and your back testing substantiate 10% as a valid arbitrary rule? If so, I would be interested to see your research.

My idea is that, assuming that you are trading on technical analysis, a stop should be situated where your trade has gone wrong based on what your technical analysis trading model suggests should happen. Without full knowledge of the logic of your trading plan, I am unable to comment on how valid a 10% arbitrary stop would be. Instead let me try to use an example of my reasoning.

Let’s assume that your method is to trade an uptrend using a 22-day exponential moving average (EMA). This implies that your model would be that while the price stays (or closes) above the EMA, the trade is proceeding to plan. However, if the price falls (or closes) below the EMA, then the uptrend has failed.

If this was your plan, a 10% arbitrary stop would make no sense at all.

If the EMA was only 5% below your last closing price, then a 10% stop would be far too late to act on the logic of your plan.

If the EMA was 15% below your last closing price then a 10% stop would close you out while your trade was still on perfect track.

As I said at the start, to assess the idea of a 10% arbitrary stop, I would have to know the logic of your plan and see the research that supports it. I do not even pretend to know everything, but I have never been shown any system where an arbitrary percentage stop makes any sense in terms of the logic of the trading plan or which is based on researching many past situations.

I will say, though, that a 10% arbitrary stop might be better than having no stop at all.

However, it seems to me that arbitrary stops can result in late decisions on failed trades, such that the loss is greater than it should be, or premature decisions on successful trades that miss out on potential additional profits.