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.Up to this point, our focus on risk management has been primarilydefensive.In other words, we have focused on those elements of tradingstrategy design that protect our trading equity if the trade is simply wrong.There is another entirely different and more pleasant aspect of money man-agement, however, that occurs when a trade has begun to produce a profitin its open equity.This stage of money management might best be calledprofit management.Let us explore this aspect now.THE MANAGEMENT OF PROFITThis area is as potentially complex as is that of risk management.Whereasthe focus appears to be different, profit management is also about thepreservation of trading capital.The major difference is that it is about thepreservation of open trading profit.Its main focus is to capture as muchprofit as possible from a trade while avoiding the cost of premature exitfrom a trade that is riding a trend that is still not finished.There are twomain methods to preserve open equity profit: the trailing stop and the profit,or target, order.The Trailing StopDefinition: A trailing stop is a dynamic order that moves up with new highs(long) or down with new lows (short) in the market so as to preserve somepredetermined proportion of open trade profit.The trailing stop is constructed in a manner that continuously ad-vances a stop in the direction of a profitable market move during the life ofthe trade.A trailing stop to protect a long position will move up as the mar-ket advances.A short trailing stop protects a short position in a decliningmarket.It is also central to the concept of the trailing stop that it does notretreat.In other words, once a new high or low has been established anda new higher or lower trailing stop has been calculated, it is never movedlower or higher if the market moves against the trade.The ideal trailing stop preserves as much open trading profit as possi-ble while at the same time providing enough breathing room to encompassthe market volatility that is a part of all trades.The vast majority of trades c05 JWPR070-Pardo December 14, 2007 13:59 Char Count=86 THE EVALUATION AND OPTIMIZATION OF TRADING STRATEGIESdo not go straight in one direction without pullback.Ideally, the trailingstop will allow for these natural pullbacks and exit when the main thrustof the trade is ended.There are endless potential trailing stop variations.Let us look atexamples of two relatively common types of trailing stops: dollar andvolatility.Definition: A trailing dollar profit stop is an order to exit a positionand is set at a fixed dollar value above the most current low price (short)or below the most current high price (long).For example, assume a dollar trailing stop of $1,000 (where $1,000 isequal to 2 points), a long position of 350, and a current market high of356.00.The trailing sell stop on this long position is 354 (356.00 2.00 =354.00).If price subsequently goes against the long position and fallsthrough this sell exit trailing stop, the position is exited with a $2,000 profitminus commission and slippage.A trailing buy stop for a short position isthe reverse.Definition: A trailing volatility profit stop is an order to exit a positionand is set at a point value based upon some measure of market volatilityabove the most current low price (short) or below the most current highprice (long).Let us assume that:1.The daily range (high minus low) is our basic unit of volatility2.We will use 50 percent of volatility for our stop point values3.A three-day average of daily ranges is our measure of volatilityGiven this, assume a three-day average volatility today of 5.50 points.Fifty percent of 5.50 points is 2.75 points.Assume a long position of 350 and a current market high price of356.00.The trailing sell stop on this long position then is 353.25 (356.00 2.75 = 353.25).If price subsequently goes against the long position andfalls through this sell exit trailing stop, the position is exited with a $1,625profit minus commission and slippage.A trailing buy stop for a short posi-tion is calculated in the opposite manner using new lows.There are many ways to establish trailing stops beyond these basictypes.For the sake of illustration, three examples of different types of trail-ing stops are: the value of a moving average,support and resistance levels,and the percentage retracements of an n-period range.The key to a successful trailing stop is to find that price level in thelife of a trade, which, if penetrated, tells us that the move captured by theprofitable trade is over.Of course, there are many ways to do this and itis left to the strategist to find that style of trailing stop most organicallysuitable to his strategy. c05 JWPR070-Pardo December 14, 2007 13:59 Char Count=The Elements of Strategy Design 87The Impact of Overnight Changeon the Trailing StopA trailing stop is dynamic, moving up or down as the market moves infavor of the trade.A trailing stop must be placed as a GTC order or enteredeach day throughout the life of the position in order to be effective.Thisstill does not entirely limit the profit to the level at which the order is set,however.Why? Once again, a large and volatile overnight close to openprice change can exceed the price level of the trailing stop.For example,if the market opens at 340, 10 points lower than the trailing stop price of350, our stop becomes a market order on the open and it will be filled atthe opening price.Overnight risk can potentially transform an open profitinto a loss.Overnight risk can and does also move in favor of our trade, ofcourse.Profit TargetsThe other way to protect open equity profit is to take profits when a prede-termined price level or profit threshold has been reached.There are manyways to calculate such profit target thresholds.Profit target orders are setwith price or better or price limit orders.Definition: A profit target is an unconditional exit of a trade with alocked-in profit at some predetermined price or profit level.The incorporation of a profit target into a trading system is a moreproactive and aggressive method of profit management.The most posi-tive aspect of a profit target is that once the desired profit is realized, itis captured immediately.It therefore cannot be lost like it can be witha trailing stop.The negative aspect occurs when a profit is taken andthe market continues to move well beyond this target level.These poten-tial additional gains are lost because our profit target has closed out theposition.There are trade-offs with the use of profit targets.Some traders can-not live without them just as some cannot live with them.Trading systemsthat use profit targets, in contrast to those that do not, can be less prof-itable overall but can produce a higher percentage of winning trades anda smoother equity curve.Sometimes profit targets reduce per trade, andtotal risk and overall performance can be more stable.Not all systems are improved by the use of profit targets.Whether profittargets are beneficial or not very much depends on the style and paceof the trading strategy
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