We all focus a lot of attention, perhaps too much attention, on where to buy and sell a market, on where to enter trades. Today, let’s spend some time looking at the other side: where are you getting out?
Some categories are useful here, and they are not complicated. First, we have exiting at a loss, or at a profit. (This is not necessarily the same as saying exiting on a stop or at a profit, because a (trailing) stop can often be a profit-taking technique.) Both of these can then be divided into two more categories: Exiting at the initial loss or a reduced loss, and Profit taking against a stop or at a limit. Let’s spend a few moments thinking about each of these.
The most important think about initial stops is that you have one. Though so many trading axioms and sayings do not apply universally, one that does is “know where you’re getting out before you get in.” For every trade, you should have a clearly defined maximum loss, and you should work hard to make sure that loss is never exceeded. In practice, bad things will happen. You will have the (hopefully rare) experience of a nasty gap beyond your stop, and sometimes will see losses that are whole number multiples of your initial trade risk. (I remember one lovely -4.5x loss in YHOO years ago. Though these events are rare, they are also a good reminder of we do not, for instance, risk 10% of our accounts on a trade. A 45% loss on a single trade would be a disaster, but 4.5x a reasonable risk (1% – 2%) is merely annoying.)
Initial stop placement is an art in itself, but, in general, I think too much of the material on the internet probably uses stops that are too tight. I’ve never seen anyone trade successfully with stops that are a few ticks wide. For me, initial stops usually end up somewhere around 3-4 ATRs from the entry. These stops are wide enough that many traders find them uncomfortable, but simply reducing position size to manage the nominal loss is an obvious solution. Taking losses is perhaps the most important thing you will do as a trader, so do it well and do it properly.
We have defined that initial “never to be exceeded” (ideally) stop at trade entry, but many traders find it effective to move that stop rather quickly. Another possibility to consider is the time stop, in which we take steps to limit the position risk if the trade does not move in some defined time. There are many possibilities here, ranging from tightening the stop, to reducing the position, to exiting completely.
I have made a good case for not reducing the position at a loss because it effectively “deleverages” your P&L in the “loss space.” (See the chart above, which is drawn from pages 242 and 243 of my book.) Personally, I’ve found that simply taking whole, but smaller than initial, losses is more effective, but your experience may be different. A key point here is that all of this–entry, exit, position size, moving stops, taking targets, re entries, adding to positions, partial exits, etc.–all of this must work together. You change one piece, and the whole system will change. This is why some techniques may be effective in some settings but not in others.
To simplify, think of reduced stops as being moved when the trade does not immediately go far enough in your favor, and consider the use of time stops.
Profit targets are usually limit orders, as opposed to stops (which, not surprisingly, are usually stop orders.) In general, I find that it makes sense to have profit taking limit orders working in 24 hour markets, though we may not wish to work stops in the same after hours environments. People sometimes make mistakes or do silly things in afterhours, and I’m always happy to provide liquidity at the right prices. 🙂
There is a school of thought that says that all trades should simply be exited at profit targets, while there is a conflicting school that says we must let our winners run. How to reconcile these two approaches? I think the answer lies in trading style. For trend traders, we must let our profits run. As countertrend traders, we must take quick profits, usually at pre-defined areas. I have not found chart patterns or points to be any more effective than simply setting a target 1X my initial risk on the “other side” of the entry. Many people like to use pivots or trendlines, but I’ve executed well tens of thousands of trades (one of the advantages of spending years as short-term trader) and have simply not found these to be that effective. (For intraday traders, highs and lows of the day do deserve respect.) Consider the tradeoffs in simplifying your approach.
Trailing stops can be managed in many ways, and I have found these to be very effective in many types of trading. We can trail at some volatility-adjusted measure, and there are even times we trail a very tight stop, effectively hoping to be taken out of the trade. This is a good problem to have: sometimes you may trail a stop at yesterday’s low, and be shocked as the trade grinds in your favor week after week–there’s nothing to be done in these cases but be forced to stay in the trade and make more money, but guard against hubris: many of the times this has happened to me I have been properly positioned into a climax move. When these moves end, they often end dramatically, so simply ring the register and step away from the market.
Putting it all together
This is certainly not an exhaustive list of all the possible ways to exit trades, but it will get you started in the right direction. I find that combining these techniques, using a pre-defined target for part of the trade, trailing the stop on the rest, and moving quickly to reduce initial risk on my rather wide initial stops, this works very well for swing trading the markets I follow. (If you want to see me do this in real time, I invite you take a free trial of the research I write for Waverly Advisors ever day.)
Consistency certainly matters, but consistently doing something that works will, not surprisingly, lead to consistently losing money. Make sure you have a well-designed system with an edge, and that the system is one you can follow in actual trading. Make sure you trade with appropriate size and risk, and that you monitor your performance accordingly. With these guidelines, you can be a few steps closer to developing your own system and approach to trading.