Stops

The traditional method to reduce drawdowns even further, provided they are not a series of losses, is the use of stop levels. These levels signal when a system position has reached a point where it is in danger of producing a large drawdown and should be closed.

As explained in Chapter 4, “Systems Analysis,” there are many stop methods. The two I use are the protective stop and the trailing stop. The protective stop is placed at a specific percentage below the entry price and protects the initial investment from a large decline. The trailing stop follows the price in the direction of the trade and exits once the price reverses by a specified amount. For a trailing stop, I could use either a profit-percentage trailing amount or an average true range (ATR) volatility stop. The percentage method has a weakness in that it is fixed regardless of the volatility of the price. The percentage-trailing stop works in the instance when volatility widens the ATR stop range at some major market tops and thus delays the stop signal. For this reason, it is....