Adrian Reid explains why limit orders in trend-following systems can backfire: they cut slippage but make you miss gap-up opens, often the year's best trades. He recommends adaptive algorithmic orders instead and stresses backtesting the tradeoff.
We've got a trend following system. We're buying a breakout. Can we use a limit order to get in to reduce slippage? The answer is yes. You also want to make sure that by placing a limit order, you don't reduce your chances of getting the trade and therefore degrade the system. So you need to backtest it. The problem is sometimes the stocks that move the most strongly on the entry day are the stocks that turn out to be the best trades. And if you have a limit order that prevents you from getting into those because because they gapped up too much, then you can miss out on the best trade of the day or even the best trade of the year. So when you backtest a trend following system with a limit order entry, what you'll expect to see is some of the best trades get missed by the system because they open above the limit entry price that you set. And then you get a lot less slippage on the remaining trades. So a bit of a trade-off here between avoiding the slippage and missing out on some of the best trades that just rocket ahead and you have to chase them a little bit to get in.. But this is part of trend following and it's one of the most difficult psychological aspects of it. Sometimes the most uncomfortable trades to get into turn out to be the best trades of all. So I generally use adaptive market algo orders to get into trend following trades because I don't wanna miss the very best trades that blast off right from the open or trades that gap up at the open because they're gonna move so strongly for the rest of the day. I'd rather take that risk but get into the trade then reduce the slippage and reduce the chance that I have to pay extra because there was a gap up and use a limit order system. But this is up to you and it's something that you need to backtest to make sure that you are getting the right trade-off or the best trade-off for your particular system. So if you want more tips about systematic trading, make sure that you like this video and subscribe to Enlightened Stock Trading so you don't miss the next one.
