The Importance of Exit Strategy – Part 2

In part one of this article, we considered a few questions:

  • Should we use a tight stop loss to cut any losses quickly, or a wide stop loss to allow some room to move?
  • How quickly should we move the stop loss to breakeven?
  • Should we take profits at a target, or should we let the profits run, perhaps trailing a stop behind the price?

 

In attempting to answer these questions we looked at a number of charts, we chose an entry criteria, and then looked at possible options for the exit.

And this is what we discovered:

  • Firstly, in each case, the profit or loss taken out of the trade was more a result of our chosen stop and exit method, not our entry. For the same entry, there were numerous possible exits, some profitable, some breakeven and some at a loss.
  • And secondly, we cannot know, except with hindsight, what will be the most profitable exit strategy for that particular trade.

 

In other words – the exit is more important than the entry. The exit has more bearing on whether the trade ends in profit, or in loss. But there can be no perfect exit strategy that best manages every trade.

Sometimes we are better off with a wide stop. Sometimes we are better off with a tight stop. And for ongoing management of the trade, sometimes in hindsight the best results would have come from exiting a target price. Other times the best results come from trailing a stop.

So what’s a trader to do?

In this part of the article, I’d like to discuss the some of the principles or personal beliefs that I used in formulating an exit plan. Coming up then in part three, we’ll examine my exit strategy, and share some advice from great authors and traders who have shaped my current beliefs regarding exits.

As always, don’t believe a word I say. This is simply what works for me, based on some of my market beliefs. I’m serious – you need to test everything. If what works for me contradicts or is incompatible with your style of trading, then it probably won’t work for you, either technically or psychologically. By all means try it. But journal your trading results, and review them to learn your lessons, retain what works, and discard or improve what’s not working.

Enough of that – let’s get onto exits.

 

BELIEF #1 – Fixed rules don’t work

At least none that I know of!

I am assuming from some of the email feedback I received over the last week, that people were hoping I was going to present the ‘holy grail’ exit rule, along the lines of:

  • “If the standard deviation of the 14 period average true range (ATR) is less than 2/3 of π times the 3 period ATR, then set the stop at 1.8 ATR, else 2.5 ATR. Now set your stop and walk away.”

 

Sorry folks, that’s not how I work. And I’m really sorry if that disappoints you. By all means, test that last rule, but do not trade with it because I really did just make it up. The fact is that I don’t know of any objective rule like this that you can apply to ensure you get the best type of exit each time. As we discovered in part one, you CANNOT know which exit would have worked the best, until the trade is history. The good news though is that you don’t need a fixed rule like this.

 

BELIEF #2 – You will never perfect your exit strategy.

Case in point – Larry Connors, co-author of ‘Street Smarts’ with Linda Bradford Raschke, recalls in that book a retired friend of his who made over $100 million trading futures who stated that his biggest weakness was that he never mastered his exit strategy.

If you haven’t mastered your exit strategy, then don’t worry – you’re in good company.

I haven’t mastered mine either, and although I’m still well short of my $100 million, I am comfortable with the imperfection of my exits.

You need to accept imperfection. You need to accept less than ideal results. When you conduct discretionary backtesting, and look at the chart, and say, “I would have exited that one at the minor resistance area here”, or “I would have trailed that one.” Well, accept that you probably wouldn’t have done that. Your live results will not be as good as the charts look in hindsight. But that’s fine.

 

BELIEF #3 – The real damage is psychological, not financial.

The real damage done by taking a large loss is not necessarily the financial damage, but rather the psychological damage. Holding a loss past the stops digs a hole that psychologically is very hard to get out of.

The real damage done by exiting a trade for a small profit and then watching it blast off without you, to what could have been the trade of your life, is not financial – lost opportunity didn’t cost you any money. Rather, the real damage is psychological.

The damage through watching a profitable trade turn around and go right through breakeven to exit at the maximum stop, is not financial, but psychological.

We are human, so single trade errors will happen. However, the worst mistake of all is allowing poor money or risk management to continue beyond that one trade, eroding our capital and placing us into a large drawdown. The psychological damage here is often overwhelming, and is what will take many novice traders right out of this game.

 

BELIEF #4 – Your exit strategy must be designed to match your trading psychology.

This is possibly the most important part of exits, in my opinion. If you take nothing else away, at least please consider this belief and see how it relates to your own trading.

Because of the fact that the real damage is psychological, I believe you need to design your exit strategy to best match your trading psychology. This may not necessarily be what produces greatest profits.

Do not optimize for maximum profits. Instead, optimize to ensure compatibility with your trading psychology.

Do you hate missing the big moves, more than anything? Then you need to perhaps consider wider stops, to ensure you’re not stopped out before the move, with some form of trailing stop to keep you in the market for the whole move. Of course, this wider stop will come at the cost of a lower winning percentage.

Do you hate seeing a profitable trade turn into a loss? Then you should design your exit strategy to include aggressive movement of your stop to breakeven, or a small profit. Of course, this will come at the expense of being stopped out more often on a retracement, and missing the real move.

You’ll see an example in part 3 of this article series when we look at how my exit strategy is designed to fit with my trading psychology.

 

BELIEF #5 – A good defense is better than a good offense.

Your goal is to ensure the market cannot take you out of the game. You must, before anything else, ensure you survive to trade another day.

There can be five possible outcomes from any trade:

  • Large win
  • Small win
  • Breakeven
  • Small loss
  • Large loss

 

The nature of the market is ‘uncertainty’. It doesn’t matter how certain your analysis is, you are still dealing with probabilities, and you will still face losses.

What can you, as a trader, control?

You have limited control over the profits. Yes, if the market provides a profitable move, your exit strategy determines how much profit you get, however you can’t control the size of the move the market offers you. You have to accept whatever the market provides, and just try to take your part out of the move. You have limited control over the profits.

How much you lose though, is totally within your control. If you end up taking a large loss, it’s simply because you didn’t exit for a smaller loss.

The larger losses are what can take you out of this game. If you ensure you never suffer a larger loss, then you’ll get lots of small wins, lots of small losses, lots of breakeven trades, and some big wins, but you should never suffer a big loss, and so you increase the likelihood of surviving to trade another day. We control risk to ensure we do not get big losses.

 

BELIEF #6 – Different exit styles produce better results in different market conditions

In a choppy sideways market, taking profits at pre-determined price targets will generally over time produce better results than trailing a stop.

In a smoothly trending market with what I call nice flow, a trailing stop will generally over time produce better results than taking profits.

Fairly obvious so far! However I also believe that in a trending market, that trends with a very volatile and choppy price action, once again taking profits at pre-determined price targets on each of the swings will generally over time produce better results than trailing a stop.

So, how does your market move? This should influence your trading style and exit management. And does this still suit your psychological requirements we discussed earlier?

 

BELIEF #7 – Stop placement involves a trade-off between winning percentage and the ratio of average-win to average-loss

We saw this briefly when we discussed psychology.

When we use stop loss management in to attempt to increase our winning percentage, it often comes at the cost of a smaller average win/loss ratio, through either smaller average wins or larger average losses.

For example, widening your initial stop will increase your percentage of winning trades by giving price more room to move into profit without being stopped out, but this will come at the expense of a larger average loss on those occasions you do get stopped out.

And when we use stop loss management in an attempt to increase our average win/loss ratio, it often comes at the cost of a smaller percentage of winning trades.

For example, tightening up your initial stop will result in your losing trades being smaller in size, and possibly increasing your average win/loss ratio. However, your winning percentage will also be decreased, simply because you will now be stopped out more often.

The same applies when considering targets. It seems very common for people to give trading advice, that you should set your stop and then place a profit target at two times the risk, or three times the risk. By increasing the size of your average wins to 2 or 3 times of the size of your average loss like this, you will automatically incur a reduction in winning percentage. You can’t avoid that.

So this brings us back to psychology. What are you more comfortable with, a small percentage of winning trades, but bigger profits when you do win, or a large percentage of winning trades, being happy with smaller wins each time?

I know! You want a large percentage of wins with each one of them being large. Dream on – it just doesn’t happen.

 

BELIEF #8 – Initial stop loss placement should be at a point that says your analysis or timing was wrong.

Keep your stops as tight as you can, but make sure they’re beyond the noise of the market. If your analysis and timing was correct, the price should never get to the stop.

So, set stops based on the price action, not just based on how many dollars you are willing to lose. If the price action requires too much dollar risk, then lower your position size to reduce the risk accordingly, or just pass on this trade.

 

BELIEF #9 – When the edge is gone, get out

You don’t need to hold your trade till it stops out. No-one is making you stay in the market. Simply put, if the price is not moving how you expected after entry, then get out. You can always get back in again later if another setup or trigger occurs.

In fact this is a great way to increase the average win to average loss ratio, not by increasing the size of your average win, but by reducing the size of your average loss.

A lot of people won’t take trades which offer less than a 2:1 win/loss ratio. I’ll accept 1:1 any time, because I aim to not let the trade hit the stop. If price shows the edge is gone, I’m out of there. So my average loss will therefore be less than 1.

So, let’s take a short break to allow you to absorb this, and in part 3 we’ll continue by reviewing my approach to intraday trading stop management, and then looking at some great advice from traders and trading educators who have played pivotal roles in shaping my exit beliefs.

Lance Beggs

 


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2 Comments to “The Importance of Exit Strategy – Part 2”

  1. Tony says:

    Great article on exit strategy!
    Thanks for sharing your knowledge!

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