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methodologies are useful in the process of deciding when, where, and how to enter
a trade was examined. Tests were conducted on everything from cycles to sunspot
activity, from simple rule-based approaches to advanced genetic algorithms and
neural networks. In order that a reasonably fair comparison of entry methods could
be made, the exit strategy was intentionally kept simple and constant across all
tests. A fixed money management stop, a profit target limit, and an exit at market
after a given number of bars, or days, in the trade were used. In Part III, attention
will be shifted to the problem of how to get out of a trade once in, i.e., to exit strate-
gies, an issue that has often been neglected in the trading literature.

THE IMPORTANCE OF THE EXIT
In many ways, a good exit is more critical and difficult to achieve than a good entry.
The big difference is that while waiting for a good opportunity to enter a trade, there
is no market risk. If one opportunity to enter is missed, another will always come
along-and a good, active trading model should provide many such opportunities.
When a trade is entered, however, exposure to market risk occurs simultaneously.
Failing to exit at an appropriate moment can cost dearly and even lead to the dread-
ed margin call! We actually know someone who made a quick, small fortune trad-
ing, only to lose it all (and then some) because the exit strategy failed to include a
good money management stop! To get out of a trade that has gone bad, it is not a
good idea to simply wait for the next entry opportunity to come along. Similarly,
erring on the side of safety and exiting at the drop of a hat can also drain a trading
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account, albeit less dramatically through slow attrition. The problem with frequent
and hasty exits is that many small losses will occur due to the sacrifice of many
potentially profitable trades, and trades that are profitable will be cut short before
reaching their full profit potential. A good exit strategy must, above all, strictly con-
trol losses, but it must not sacrifice too many potentially profitable trades in the
process; i.e., it should allow profitable trades to fully mature.
How important is the exit strategy? If risk can be tightly controlled by quick-
ly bailing from losing trades, and done in such a way that most winning trades am
not killed or cut short, it is possible to turn a losing system into a profitable one!
It has been said that if losses are cut short, profits will come. A solid exit strategy
can, make a profitable system even more lucrative, while reducing equity volatili-
ty and drawdown. Most importantly, during those inevitable bad periods, a good
exit strategy that incorporates solid money management and capital preservation
techniques can increase the probability that the trader will still be around for the
next potentially profitable trade.

GOALS OF A GOOD EXIT STRATEGY
There am two goals that a good exit strategy attempts to achieve. The first and
most important goal is to strictly control losses. The exit strategy must dictate how
and when to get out of a trade that has gone wrong so that a significant erosion of
trading capital can be prevented. This goal is often referred to as money manage-
ment and is frequently implemented using stop-loss orders (money management
stops). The second goal of a good exit strategy is to ride a profitable trade to full
maturity. The exit strategy should determine not only when to get out with a loss,
but also when and where to get out with a profit. It is generally not desirable to
exit a trade prematurely, taking only a small profit out of the market. If a trade is
going favorably, it should be ridden as long as possible and for as much profit as
reasonably possible. This is especially important if the system does not allow mul-
tiple reentries into persistent trends. “The trend is your friend,” and if a strong
trend to can be ridden to maturity, the substantial profits that will result can more
than compensate for many small losses. The protit-taking exit is often implement-
ed 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.

KINDS OF EXITS EMPLOYED IN AN EXIT
STRATEGY
There are a wide variety of exit types to choose from when developing an exit
strategy. In the standard exit strategy, only three kinds of exits were used in a sim-
ple, constant manner. A fixed money management exit was implemented using a
stop order: If the market moved against the trade more than a specified amount.
the position would be stopped out with a limited loss. A p&It rarget exit was
implemented using a limit order: As soon as the market moved a specified amount
in favor of the trade, the limit would be hit and an exit would occur with a known
profit. The time-based exir was such that, regardless of whether the trade was prof-
itable, if it lasted more than a specified number of bars or days, it was closed out
with an at-the-market order.
There are a number of other exit types not used in tbe standard exit strategy:
trailing exits, critical threshold exits, volatility exits, and signal exits. A trailing
exit, usually implemented with a stop order and, therefore, often called a trail-
ing “top, may be employed when the market is moving in favor of the trade. This
stop is moved up, or down, along with the market to lock in some of the paper
profits in the event that the market changes direction. If the market turns against
the trade, the trailing stop is hit and the trade is closed out with a proportion of
the profit intact. A critical threshold exit terminates the trade when the market
approaches or crosses a theoretical barrier (e.g., a trendline, a support or resis-
tance level, a Fibonacci retracement, or a Gann line), beyond which a change in
the interpretation of current market action is required. Critical threshold exits
may be implemented using stop or limit orders depending on whether the trade
is long or short and whether current prices are above or below the barrier level.
If market volatility or risk suddenly increases (e.g., as in the case of a “blow-off
top), it may be wise to close out a position on a volatility exit. Finally, a signal
exit is simply based on an expected reversal of market direction: If a long posi-
tion is closed out because a system now gives a signal to go short, or because an
indicator suggests a turning point is imminent, a signal exit has been taken.
Many exits based on pattern recognition are signal exits.


Money Management Exits
Every exit strategy must include a money management exit. A money management
exit is generally implemented using a stop order. Therefore, it is often referred to
as a money management stop. Such a stop closes out a trade at a specified amount
of adverse excursion (movement against the trade), or at a specified price below
(if long) or above (if short) the price at which the trade was entered. A money man-
agement stop generally stays in place for the duration of the trade. Its purpose is
to control the maximum risk considered tolerable. Of course, the potential risk
may be greater than what was expected. The market could go limit up (or down)
or have a large overnight gap. Trading without a money management stop is like
flying in a rickety old plane without a parachute,
The issue is not whether a money management stop should be used. Rather,
it is determining the optimal placement of the stop. There are many ways to decide
where to place money management stops, The simplest placement occurs by
assessing the maximum amount of money that can be risked on a given trade. For
example, if a trade on the S&P 500 is entered and the trader is not be willing to
risk more than $1,500, a money management stop that uses a $1,500 stop-loss
order would be specified. If the market moves against the trade more than $1,500
(three S&P points), the stop gets hit and the position is closed out. Another way to
set the money management stop is on the basis of volatility. In volatile markets and
periods, it may be a good idea to give trades more room to breathe, i.e., to avoid
having the stop so close to the market that potentially profitable trades get stopped
out with losses.
A good way to set a money management stop is on the basis, of a price bar-
rier, such as a trendline or support/resistance level. In such cases, the stop also
serves as a critical threshold exit. For example, if there are a number of trend and
support lines around 936.00 on the S&P 500, and a long position at 937.00 has just
been entered, it might be worth considering the placement of a stop a little below
936.00, e.g., at 935.50. Setting a protective stop at 935 is logical since a break
through support suggests that the trend has changed and that it is no longer smart
to be long the S&P 500. In this example, only $750 is at risk, substantially less
than the $1,500 risked when using the money management stop that was based on
a dollar amount. A tighter stop can often be set using a barrier or critical price
model than would be the case using a simple dollar-amount model.
As hinted above, setting a money management stop involves a compromise. It
is good to have a very tight stop, since losing trades then involve only tiny, relatively
painless losses. However, as the stop is righrened (i.e., moved closer to the entry or
current price), the likelihood of it getting triggered increases, even if the market even-
tually moves in favor of the trade. For example, if a $50 stop loss is set, almost all
trades on the S&P 500, regardless of entry method, will be stopped out with small
losses. As a stop gets tighter, the percentage of winning trades will decrease. The stop
eventually ends up sacrificing most of what would have been profitable trades. On the
other hand, if the stop is too loose, although the winning trades are retained, the
adverse excursion on those winners, and the losses on the losing trades, will quickly
become intolerable. The secret is to find a stop that effectively controls losses with
out sacrificing too many of the trades that provide profits.

Trailing Exits
A rrailing exit is usually implemented with a so-called trailing stop. The purpose
behind this kind of exit is to lock in some of the profits, or to provide protection
with a stop that is tighter than the original money management stop, once the mar-
ket begins to move in the trade™s favor. If a long position in the S&P 500 is taken
and a paper profit ensues, would it not be desirable to preserve some of that prof-
it in case the market reverses? This is when a trailing stop comes in useful. If a
$1,500 money management stop is in place and the market moves more than
$1,500 against the trade, the position is closed with a $1,500 loss. However, if the
market moves $1,000 in the trade™s favor, it might be wise to move the old money
management stop closer to the market™s current price, perhaps to $500 above the
current market price. Now, if the market reverses and the stop gets hit, the trade
will be closed out with a $500 profit, rather than a $1,500 loss! As the market
moves further in favor of the trade, the trailing stop can be moved up (or down, if
in a short position), which is why it is called a trailing stop, i.e., it is racheted up
(or down), trailing the market-locking in more of the increasing paper profit.
Once it is in place, a good trailing stop can serve both as an adaptive money
management exit and as a profit-taking exit, all in one! As an overall exit strategy,
it is not bad by any means. Trailing stops and money management stops work hand
in hand. Good traders often use both, starting with a money management stop, and
then moving that stop along with the market once profits develop, converting it to
a trailing stop. Do not be concerned about driving the broker crazy by frequently
moving stops around to make them trail the market. If trading is frequent enough
to keep commissions coming in, the broker should not care very much about a few
adjustments to stop orders. In fact, a smart broker will be pleased, realizing that
his or her client is much more likely to survive as an active, commission-produc-
ing trader, if money management and trailing stop exits are used effectively.
How is the placement of a trailing stop determined? Many of the same prin-
ciples discussed with regard to money management exits and stops also apply to
trailing exits and stops. The stop can be set to trail, by a fixed dollar amount, the
highest (or lowest, if short) market price achieved during the trade. The stop can
be based on a volatility-scaled deviation. A moving threshold or barrier, such as a
trend or Gann line, can be used if there is one present in a region close enough to
the current market action. Fixed barriers, like support/resistance levels, can also be
used: The stop would be jumped from barrier to harrier as the market moves in the
trade™s favor, always keeping the stop comfortably trailing the market action.

Profit Target Exits
A projit target exit is usually implemented with a limit order placed to close out a
position when the market has moved a specified amount in favor of the trade. A
limit order that implements a profit target exit can either be fixed, like a money
management stop, or be moved around as a trade progresses, as with a trailing
stop. A fixed profit target can be based on either volatility or a simple dollar
amount. For example, if a profit target of $500 is set on a long trade on the S&P
500, a sell-at-limit order has been placed: If the market moves $500 in the trade™s
favor, the position is immediately closed. In this way, a quick profit may be had.
There are advantages and disadvantages to using a profit target exit. One
advantage is that, with profit target exits, a high percentage of winning trades can
be achieved while slippage is eliminated, or even made to work in the trader™s
favor. The main drawback of a profit target exit is that it can cause the trader to
prematurely exit from large, sustained moves, with only small profits, especially
if the entry methods do not provide for multiple reentries into ongoing trends. All
things being equal, the closer the profit target is to the entry price, the greater the
chances are of it getting hit and, consequently, the higher the percentage of win-
ning trades. However, the closer the profit target, the smaller the per-trade profit.
For instance, if a $50 profit target is set on a trade in the S&P 500 and the money
management stop is kept far out (e.g., at $5,000), more than 95% of the trades will
be winners! Under such circumstances, however, the wins will yield small profits
that Will certainly be wiped out, along with a chunk of principal, by the rare $5,000
loss, as well as by the commissions. On the other hand, if the profit target is very
wide, it will only occasionally be triggered, but when it does get hit, the profits
will be substantial. As with exits that employ stops, there is a compromise to be
made: The profit target must be placed close enough so that there can be benefit
from an increased percentage of winning trades and a reduction in slippage, but it
should not be so close that the per-trade profit becomes unreasonably small. An
exit strategy does not necessarily need to include a profit target exit. Some of the
other strategies, like a trailing stop, can also serve to terminate trades profitably.
They have the added benefit that if a significant trend develops, it can be ridden to
maturity for a very substantial return on investment. Under the same conditions,
but using a profit target exit, the trade would probably be closed out a long time
before the trend matures and, consequently, without capturing the bulk of the prof-
it inherent in the move.
Personally, we prefer systems that have a high percentage of winning trades.
Profit targets can increase the percentage of wins. If a model that is able to reen-
ter active trends is used, profit target exits may be effective. The advantages and
disadvantages really depend on the nature of the system being trading, as well as
on personal factors.
One kind of profit target we have experimented with, designed to close out
dead, languishing trades that fail to trigger other types of exits, might be called a
shn™nking target. A profit target that is very far away from the market is set.
Initially, it is unlikely to be triggered, but it is constantly moved closer and closer
to where the market is at any point in the trade. As the trade matures, despite the
fact that it is not going anywhere, it may be possible to exit with a small profit
when the profit target comes into a region where the market has enough volatility
to hit it, resulting in an exit at a good price and without slippage.

Time-Based Exits
Time-based exits involve getting out of the market on a market order after having
held a trade for a fixed period of time. The assumption is that if the market has not,
in the specified period of time, moved sufficiently to trigger a profit target or some
other kind of exit, then the trade is probably dead and just tying up margin. Since
the reason for having entered the trade in the first place may no longer be relevant,
the trade should be closed out and the next opportunity pursued.

Volatility Exits
A volatility exit depends on recognizing that the level of risk is increasing due to
rapidly rising market volatility, actual or potential. Under such circumstances, it is
prudent to close out positions and, in so doing, limit exposure. For instance, when
volatility suddenly expands on high volume after a sustained trend, a “blow-off
top might be developing. Why not sell off long positions into the buying frenzy?
Not only may a sudden retracement be avoided, but the fills are likely to be very
good, with slippage working with, rather than against, the trader! Another volatil-
ity exit point could be a date that suggests a high degree of risk, e.g., anniversaries
of major market crashes: If long positions are exited and the market trends up
instead, it is still possible to jump back in. However, if a deep downturn does
occur, the long position can be reentered at a much better price!
What else constitutes a point of increased risk? If an indicator suggests that
a trend is about to reverse, it may be wise to exit and avoid the potential reversal.
If a breakout system causes a long entry into the S&P 500 to occur several days
before the full moon, but lunar studies have shown that the market often drops
when the moon is full and the trade is still being held, then it might be a good idea
to close the position, thus avoiding potential volatility. Also remember, positions
need not be exited all at once. Just a proportion of a multicontract position can be
closed out, a strategy that is likely to help smooth out a trader™s equity curve.

Barrier Exits
A barrier exit is taken when the market touches or penetrates some barrier, such as a
point of support or resistance, a trendline, or a Fibonacci retracement level. Barrier
exits are the best exits: They represent theoretical barriers beyond which interpretation
of market action must be revised, and they often allow very close stops to be set, there-
by dramatically reducing losses on trades that go wrong. The trick is to find a good
barrier in approximately the right place. For example, a money management stop can
serve as a barrier exit when it is placed at a strong support or resistance level, if such
a level exists close enough to the entry price to keep potential loss within an accept-
able level. The trailing exit also can be a barrier exit if it is based on a trendhne.

Signal Exits
Signal exits occur when a system gives a signal (or indication) that is contrary to
a currently held position and the position is closed for that reason. The system gen-
erating the signal need not be the same one that produced the signal that initiated
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the trade. In fact, the system does not have to be as reliable as the one used for
trade entry! Entries should be conservative. Only the best opportunities should be
selected, even if that means missing many potential entry points, Exits, on the
other hand, can be liberal. It is important to avoid missing any reversal, even at the
expense of a higher rate of false alarms. A missed entry is just one missed oppor-
tunity out of many. A missed exit, however, could easily lead to a downsized
account! Exits based on pattern recognition, moving average crossovers, and
divergences are signal exits.

CONSIDERATIONS WHEN EXITING THE MARKET
There are a number of issues to take into account when attempting to exit the mar
ket. Some orders, such as stops, may result in poor executions and substantial
transaction costs due to such factors as “gunning” and slippage. Other orders, such
as limits, may simply not be filled at all. There are also trade-offs to consider; e.g.,
tight stops might keep losses small but, at the same time, kill potentially winning
trades and increase the number of losses, Loose stops allow winning trades to
develop, but they do so at the cost of less frequent, but potentially catastrophic,
losses. In short, there are aspects to exiting that involve how the orders are placed
and how the markets respond to them.

Gunning
Sometimes putting stops in the market as they really are may not be prudent, espe-
cially when tight stops are being used Floor traders may try to gun the stops to pick
up a few ticks for themselves. In other words, the floor traders may intentionally try
to force the market to hit the stops, causing them to be executed. When stops are taken
out this way, the trader who placed them usually ends up losing. How can this be
avoided? Place a catastrophe stop with the broker, just in case trading action cannot
be taken quickly enough due to busy phones or difficult market conditions. The cat-
astrophe stop is placed far enough away from the market that it is beyond the reach
of gunning and similar “mischief.” No one would like to see this stop hit, but at least
it will keep the trader from getting killed should something go badly wrong. The real
stop should reside only with the trader, i.e., in the system on the computer: when this
stop gets hit, the computer displays a message and beeps, at which time the broker
can be immediately phoned and the trade exited. Handled this way, tight stops can be
used safely and without the risk of being gunned.

Trade-Offs with Protective Stops
Usually, as stops are moved in tighter, risk control gets better, but many winning
trades could be sacrificed, resulting in the decline of profit, Everyone would love
to use $100 stops in the S&P 500 because the losses on losing trades would be fair-
ly small. However, most systems would lose 95% of tbe time! Certain systems
allow stops to be tight, just because of the way the market moves relative to the
entry point. Such systems yield a reasonable percentage of winning trades. When
developing systems, it is good to build in a tight stop tolerance property. Such sys-
tems are often based on support and resistance or other barrier-related models.
Many systems do not have a tight stop characteristic and so require wider stops.
Nevertheless, there is always a trade-off between having tight stops to control risk,
but not so tight that many winning trades are sacrificed. Loose stops will not sac-
rifice winning trades, but the bad trades may run away and be devastating. A com-
promise must be found that, in part, depends on the nature of the trading system
and the market being traded.

Slippage
Slippage is the amount the market moves from the instant the trading order is
placed or, in the case of a stop, triggered, to the instant that order gets executed.
Such movement translates into dollars. When considered in terms of stops, if the
market is moving against the trade, the speed at which it is moving affects the
amount that will be lost due to slippage. If the market is moving quickly and a
stop gets hit, a greater loss due to slippage is going to be experienced than if the
market was moving more slowly. If there was a stop loss on the S&P 500 of $500
and the market really started moving rapidly against the trade, $200 or $300 of
slippage could easily occur, resulting in a $700 or $800 loss, instead of the $500
loss that was anticipated. If the market is moving more slowly, then the slippage
might only be $25 or $50, resulting in a $525 or $550 loss. Slippage exists in all
trades that involve market or stop orders, although it may, in some circumstances,
work for rather than against the trader. Limit orders (e.g., “sell at $2 or better”)
are not subject to slippage, but such orders cannot close out a™position in an
emergency.

Contrarian Trading
If possible, exit long trades when most traders are buying, and exit short trades
when they are selling. Such behavior will make it easier to quickly close out a
trade, and to do so at an excellent price, with slippage working for rather than
against the trader. Profit targets usually exit into liquidity in the sense just dis-
cussed. Certain volatility exits also achieve an exit into liquidity. Selling at a blow-
off top, for example, is selling into a buying frenzy! “Buy the rumor, sell the news”
also suggests the benefits of selling when everyone starts buying. Of course, not
all the exits in an exit strategy can be of a kind that takes advantage of exiting
into liquidity.
Conclusion
A complete exit strategy makes coordinated, simultaneous use of a variety of exit
types to achieve the goals of effective money management and profit taking. Every
trader must employ some kind of catastrophe and money management stop. It is also
advisable to use a trailing stop to lock in profits when the market is moving in the
trade™s favor. A risk- or volatility-based exit is useful for closing positions before a
stop gets hit-getting out with the market still moving in a favorable direction, or at
least not against the trade, means getting out quickly and with less slippage.

TESTING EXIT STRATEGIES
In the next few chapters, a variety of exit strategies are tested. In contrast to entries,
where an individual entry could be tested on its own, exits need company. An entire
exit strategy must be tested even if, for purposes of scientific study, only one element
at a time is altered to explore the effects. The reason for this involves the fact that an
exit must be achieved in some fashion to complete a trade. If an entry is not signaled
now, one will always come along later. This is not so with an exit, where exposure to
market risk can become unlimited over time, should one not be signaled. Consider,
for example, a money management stop with no other exit. Are looser stops, or per-
haps the absence of any money management stop, better than tight ones? The first test
determines the consequences of using a very loose stop. If the no-stop condition was
the first tested, there would be no trades to use to evaluate money management stops;
i.e., there would only be an entry to a trade from which an exit would never occur.
With a loose stop, if the market goes in favor of the trade, perhaps the trade would be
held for years or never exited, leading to the same problem as the no-stop condition.
These examples illustrate why exits must be tested as parts of complete, even if sim-
ple, strategies, e.g., a stop combined with a time limit exit.
For the aforementioned reasons, all the tests conducted in Chapter 13 employ a
basic exit strategy, specifically, the standard exit strategy (and a modification thereon
used throughout the study of entries; this will provide a kind of baseline. In Chapters
14 and 1.5, several significant variations on, and additions too, the standard exit will
be. tested. More effective stops and profit targets, which attempt to lock in profit with-
out cutting it short, are examined in Chapter 14. In Chapter 15, techniques developed
in the section on entries are brought into the standard exit strategy as additional com-
ponents, specifically, as signal exits. Moreover, an attempt will be made to evolve
some of the elements in the exit stmtegy. To test these various exit strategies in a man
ner that allows comparisons to be made, a set of standard entry models is needed.

STANDARD ENTRIES FOR TESTING EXITS
When studying entries, it was necessary to employ a standard, consistent exit
methodology. Likewise, the investigation of exits requires the use of a standard
entry method, a rather shocking one, i.e., the random entry model. It works this
way: The market is entered at random times and in random directions. As in all
previous chapters, the number of contracts bought or sold on any entry is selected
to create a trade that has an effective dollar volatility equal to two contracts of the
S&P 500 at the end of 1998. Due to the need to avoid ambiguity when carrying
out simulations using end-of-day data, the entries used in the tests of the various
exit strategies are restricted to the open. If entry takes place only at the open, it
will be possible to achieve unambiguous simulations with exits that take place on
intrabar limits and stops. Unambiguous simulations involving such orders would
otherwise not be possible without using tick-by-tick data. As previously, the stan-
dard portfolio and test platform will be used.

The Random Entry Model
To obtain the random entries, a pseudo-random number generator (RNG) is used

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