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MONEY MANAGEMENT
Exits, Stops And Strategy
by Jeffrey Owen Katz, Ph.D., and Donna L. McCormick
Everyone's looking for entry trading signals, but what about after you're in the trade? Here are different techniques for making a graceful ? and profitable ? exit.
Previously, we focused for the most part on the timing of trading entries. We examined how useful various factors and methodologies were in helping us decide when and where to enter a trade. We tested everything from cycles to sunspot activity, from simple rule-based approaches to advanced genetic algorithms and neural networks. We kept our exit strategies simple and fairly constant across all tests so that a reasonably fair comparison of entry methods could be made. In general, we used a fixed money management stop, sometimes a profit target, and almost always an exit-at-market order after a given number of bars, or days, in the trade. Our focus was on the entry, not the exit.
This time, we will shift our attention to how to get out of a trade ? that is, the challenge of the exit strategy, a problem often neglected in trading literature.
THE IMPORTANCE OF THE EXIT
In many ways, a good exit is more critical and difficult to achieve than a good entry. Think about it: you are not subject to market risk while you're waiting for a good opportunity to enter a trade. If you miss one such opportunity, you can always wait for another to come along ? and a good, active trading model provides many such opportunities.
Once you have entered a trade, however, you are immediately exposed to market risk. Failing to exit at an appropriate moment can cost you dearly. You cannot simply wait for the next opportunity to come along to get out of a trade gone bad. Erring on the side of safety and exiting abruptly can also drain your account simply through attrition. The problem is one of many small losses due to the sacrifice of many potentially profitable trades, and of profitable trades being cut short before yielding their full profit potential. A good exit strategy must, above all, control losses strictly, but it must not sacrifice too many potentially profitable trades in the process and must allow profitable trades to fully mature.
How important is the exit strategy? If you can control your risk by quickly bailing from losing trades and without killing or cutting short too many winners, you may even be able to turn a losing system into a profitable one. A solid exit strategy can make a profitable system even more profitable while reducing equity volatility and drawdown. Most important, during those inevitable rocky periods, a good exit strategy that incorporates solid money management and capital preservation techniques can increase the probability that you will be around for the next profitable trade.
GOOD STRATEGY
There are two goals that a good exit strategy attempts to achieve. The first, and most important, is to strictly control losses. Your exit strategy must tell you how and when to get out of a trade gone wrong so that you can prevent a significant erosion of trading capital. This is known as money management and is frequently implemented using stop-loss orders.
The second goal of a good exit strategy is to ride a profitable trade to full maturity. Your exit strategy must not only tell you when to get out with a loss, but also when and where to get out with a profit. Generally, you do not want to exit a trade prematurely. If a trade is going your way, you want to ride it as long as you can, for as much profit as possible. This is especially important if your system does not allow multiple re-entries to get you back in on persistent, ongoing trends. If you can ride a strong trend to maturity, the substantial profits can more than make up for any small losses that may occur. The profit-taking exit is often implemented with trailing stops, profit targets and time- or volatility-triggered market orders.
A complete exit strategy makes coordinated use of a variety of exit types to achieve the goals of effective money management and profit taking.
FORMING AN EXIT STRATEGY
A variety of exit types are available when forming an exit strategy. Previously, we used only three kinds in a simple, fixed manner without looking at them that closely. We usually employed a fixed money management exit using a stop order. If a trade moved against us by more than a specified amount, we would be stopped out of our position with a limited loss. Often, we had a profit target exit implemented using a limit order, so that as soon as the market moved a specified amount in our favor, the limit would be hit. And we used a time-based exit; regardless of profitability, if a trade lasted more than a specified number of bars/days, we closed it out with an at-the-market order.
There are a number of other exit types, among them trailing exits, critical-threshold exits, and volatility- and signal-based exits. A trailing exit, usually implemented with a stop order, may be employed when the market is moving in your favor. It is a stop that you move up (or down) along with the market to lock in some of your paper profits, should the market change direction. If the market turns against you, your trailing stop will be hit and your trade closed out with part of your profit intact.
Your exit strategy must not only tell you when to get out with a loss, but also when and where to get out with a profit. Generally, you do not want to exit a trade prematurely. If a trade is going your way, you want to ride it as long as you can, for as much profit as possible.
Jeffrey Owen Katz is a professional trader and consultant in Selden, NY. His firm, Scientific Consultant Services, specializes in custom programming, provides expert consultation on systems development and the use of Omega Research's tools, and develops publicly available software for traders. Donna McCormick is a writer and vice president of Scientific Consultant Services.Excerpted from an article originally published in the February 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.