Latest posts by Jason Pearce (see all)
- How To Exit Trades Part II - September 7, 2017
- How To Exit Trades Part I - August 31, 2017
- Building Pyramids for Asymmetric Trading Gains Part 2 - August 7, 2017
By Jason Pearce
The Art of the Exit
In a prior post, we discussed different ways for a trader to exit positions. Professional traders assign a lot more importance to their exit strategies than they do to their entry strategies. They know that it’s the exit that has the biggest impact on whether your trade made or lost money.
We addressed getting out of losing trades and getting out of winning trades. First, we talked about using stop loss placements in order to limit the initial risk on a trade.
Measuring the Average True Range (ATR) to create a volatility-based stop loss and using price support and resistance were two of the solutions we covered.
Next, we talked about some exit strategies for taking profits in a winning trade.
Using market volatility to determine how much of a move you could expect from the market and then liquidating when the target is reached was one exit idea we touched on.
Taking profits at price support or price resistance was another.
We even discussed the use of an overbought/oversold oscillator for knowing when to bank profits on a winning trade.
Now we’re going to look at a few more ideas.
Another strategy for exiting a profitable trade is to use projections based off the market’s price structure. There are different ways to approach this.
Elliott Wave Theory is popular with many market technicians. I am not going to dive into a discussion of the details here, but the theory makes specific wave counts in a market and provides criteria of how far each wave should go.
Therefore, someone who uses Elliott Wave could simply liquidate a position whenever the price expectations for the different wave criteria are met.
Fibonacci extensions are another technical analysis tool that can be used to set price targets.
One of the best Fibonacci traders I know enters a market when it makes a pullback to a Fibonacci .382 retracement of a trend and then takes profits when it rallies to one or all of three different price targets.
The first price target is when the market has rallied off the pullback low by .618 (62%) of the size of the rally that preceded it. This is a Fibonacci contraction target.
For example, a market rallies 150 points off a low and then pulls back. Once it starts to recover, the target would be about 92.7 points (150 * .618) from the pullback low.
The second price target is symmetrical. A position is liquidated when the rally off a pullback low is the same size as the rally that preceded it.
In this case, the price symmetry target would be 150 points off the pullback low just like the initial 150-point rally.
The third and final price target is a move that is 62% larger than the initial rally that preceded the pullback. This is a Fibonacci expansion target.
So if the market makes a pullback after the initial 150-point rally, the price extension target for the new rally would be 242.7 points (150 * 1.618) off the pullback low.
Let It Ride
There’s another camp out there that believes that profit targets are not the right way to extract profits from the market.
This group says you should simply stick with the position until there’s a change in the trend.
Bill Eckhardt, Richard Dennis’ trading partner and co-creator of the successful Turtle trading experiment in the 1980s, said, “One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits.”
The thought behind this philosophy is that, when you’ve stumbled into a trade that’s working, the right course of action is usually to do nothing and allow the profits accumulate. That’s because you have absolutely no idea how for the trend will go.
Markets often move well beyond predictions and expectations and one big move can pay for tons of small losers…but you’ve got to be in for the whole ride in order to benefit from it.
Although it sounds simple, it’s psychologically hard to do.
One reason for that is because of the fear that a winning trade could reverse and all the profits evaporate. Something about how ”a bird in hand is worth two in the bush” comes to mind.
Not Completely Passive
There’s a Wall Street saying “Cut your losses and let your profits run.”
The part about letting the profits run does not mean you just sit back and let the market runaway for a while, reverse trend, and then come all the way back to where it started.
This method requires a trader to be passive as long as the market moves in their favor…
But once the market starts to give back some of the winnings, then the trader becomes active.
The strategy is simply about progressively “trailing” a stop loss order behind the market and waiting for it to finally reverse before the positions are liquidated.
As long as the market is running away, you stay in the trade and let it continue. But once it stumbles or reverses, you take the money and run.
In a prior post on pyramiding, we discussed a couple of ideas for trailing the stop orders to exit a position. You can go back and read the post for the nitty-gritty of it, but here’s a quick overview.
First, a trader can use the market volatility, preferably a multiple of the Average True Range (ATR), to set the trailing stop level.
The ATR idea is used to keep the stop loss order far enough away from the market to not get hit by random noise, yet still trail off the highest point in the move (or the lowest point in a down trend) to keep locking in more and more profits as the market moves favorably.
The market’s price structure works well for trailing protective stops, too.
If you are trading the long side of an uptrend, the assumption is that the market will continue making higher highs and higher lows. Therefore, the protective sell stop orders should be moving higher as well.
After a market makes a pullback and then returns to or surpasses the prior high of the move, the protective sell stop could be raised to just below the pullback low. If the uptrend is still intact, this should be a higher low and should not be breached.
This cycle of ratcheting the stop loss orders higher and higher after each pullback and recovery should continue on indefinitely until the position is finally stopped out.
Moving Averages Are Moving Exits
Don’t forget about the benefits of moving averages. Not only are they useful for signaling an entry for a market, they work just as well for signaling an exit for a market.
Suppose a market is in an uptrend and is staying consistently above a particular moving average.
You would simply exit once the market closes back under that moving average.
The 50-day moving average and the 200-day moving average are both popular ones to use. Recall that even Paul Tudor Jones uses the 200-day MA as one of his metrics to determine if he wants to be in a market or not.
Nothing is fool-proof, of course.
Using the 200-day MA for a trailing stop would have knocked you out of the stock market the day after the BREXIT vote in June of 2016, only to see the market turn right around the very next day and start a run to new record highs.
Of course, using the 200-day MA as a trailing stop level would have fortunately kept you in the market during all the uncertainty around last year’s US Presidential election.
If you want to explore this idea further, read the post I wrote that shows my methodology for selecting the best moving averages to use.
Battle of the Bands
Price envelopes like Donchian bands can also be used for trailing stop placements. This is where the market breaks out above or below the high or low of the last X number of days.
It is reliant on both price and time.
Even if a market hits a price congestion zone and gets stuck there for a while, the stop level set by Donchian bands may still continue to tighten. This would serve to reduce risk/lock in more profits even when the market seems to be spinning its wheels.
Recall that Richard Dennis’ group of Turtle traders used this price envelope methodology for both entering a market and exiting a market.
History shows that it worked out pretty well for them.
The Trend Is Your Friend
All of these different trailing stop techniques work well in a trending market.
It makes sense because the market is continuing to reach mostly higher highs and set mostly higher lows. So if you’re giving the market enough elbow room during the short-term corrective or reactive phases, the protective stops should go untouched.
But once the trend pauses or ends…
That’s when the wheels can come off the wagon. Stop loss orders start to get hit and positions are exited.
If new entry signals are triggered and the market does not follow through, the new protective stops are hit as well and additional losses are doled out.
Welcome to the post-trend life.
It’s a choppy environment out there. If you don’t have a method for trading ranges, this is when you should take a break and go from being a speculator to being a spectator.
While it is true that the trend is your friend, it’s not known for being a loyal friend. The day will come when that friend will bail on you. It’s like Ed Seykota says, “The trend is your friend except at the end where it bends.”
Another technique used to manage a trade is to exit half or at least part of a position once the market has moved favorably and then move the protective stop order on the remaining contracts or shares to breakeven for the rest of the position.
This idea is a combo of both the profit target strategy and the trailing stop strategy.
The objective here is to allow a trader to eliminate the risk on a trade as quickly as possible, yet still have a position to continue making profits from an ongoing trend.
The position then becomes a free trade of sorts. Some may liken it to the concept of playing with the house’s money because you have taken your original money off the table and no longer have your initial stake at risk.
One of the benefits to this strategy is that it is psychologically rewarding to bag some profits on a trade. This may both boost confidence and cause a trader to be more patient with the remainder of the position.
One way to determine if the free trade exit strategy could be beneficial to your trading methodology is to back test it against the exit strategy that you are currently using.
If you find that a lot of your losing trades initially had an open profit at some point, what would have happened if you’d initiated this strategy and turned a large position of the losers into breakeven or even small winners?
Before you get too excited, though, remember that this exit strategy also intrinsically means that every single big winning trade you previously had with your original exit strategy would have had the position size reduced –possibly by as much as half– early on. This would significantly reduce the size of the trades that were previously the big winners.
All things being equal, you have to weigh the results to see if implementing this this exit strategy is worth it.
Did it increase or decrease your bottom line?
Did your batting average go up or down?
Were the trading equity drawdown streaks bigger or smaller, longer or shorter?
You also have to prioritize which of the metrics matter the most to you personally. It is not a black and white topic. Some traders are going to be more concerned with the smoothest returns, some traders are going to be more concerned with the biggest returns.
Like every aspect of trading, developing an exit strategy is a custom-fit endeavor.
Option Hedge: The Downside
Another idea to explore is buying options as a hedge against your position in lieu of using a traditional trailing stop loss order as the market moves in your favor.
If you are long the market, you will be buying put options for protection; if you are short the market, you will be buying call options for protection.
There is an immediate downside to this strategy, though.
When you buy an option, you have to pay a premium for it. This can make a noticeable dent in your profits because you first have to recover that cost of the option via your market position.
That means your breakeven level on the trade was just moved further away from you.
For instance, suppose you are long shares of AAPL in mid-August at a price of $161.
Instead of putting in a sell stop order to liquidate if the position goes against you, perhaps you want to buy some three-month put options with a strike price of $155 to hedge the position. Currently, the cost or premium is around $5.25 per share.
That means your stock position in AAPL would have to make at least $5.25 and hit $166.25 by the time the option expires just to cover the cost of the hedge.
That represents a three percent gain –annualized at a 12% gain- that will not get booked as a profit. Instead, you’ll be using that gain on the stock to pay off your option premium.
Option Hedge: The Upside
On the other hand, there are at least two benefits to using options to manage your risk.
First, you have an absolute guarantee on what your risk is. The difference between the entry price of your position and the strike price of the option plus the option premium is the most that you can possibly lose on the trade.
Using the same example of being long AAPL at $161 and holding a $155 strike put option that costs a premium of $5.25 yields a maximum risk of $11.25 on the position ($161 – $155 + $5.25 = $11.25).
On paper, that’s the equivalent trade risk of being long at $161 with a sell stop order placed seven percent lower at $149.75.
What if AAPL moved against you be a few percentage points and then gapped seven, eight, or even ten percent lower the next day?
The slippage on the sell stop orders could be significantly more than you accounted for, resulting in a bigger-than-expected loss on the trade.
But the loss on the trade with the put option hedge does not increase.
While it’s true that the stock loss is bigger than anticipated, the gain on the put option is correspondingly bigger and offsets the loss side of the trade.
Suddenly, the risk profile of the two strategies is not exactly similar.
A second benefit to this strategy is that using options instead of stop loss orders might help preserve both financial and psychological capital in a trade campaign.
Unlike a traditional sell stop, the option will give you staying power to hold the entire position until option expiration.
If the market plunges and the put option goes deep into the money, you have the luxury of seeing if there’s a potential reversal before option expiration. You are not forced to liquidate.
This does not happen with the stop loss. A stop loss triggers your liquidation immediately. If you want back in, you’ll have to reenter and risk more money.
If you happen to be in a winning trade, you can trail the hedge by simply liquidating the put options and buy new put options with higher strikes as the trend progresses. This is the equivalent to trailing a protective stop loss order.
I know enough about the Greeks that I don’t immediately think we’re talking about the fraternity on Animal House instead of the different factors for option pricing when they are being discussed.
However, I certainly don’t claim to be the all-knowing option expert on all the various ways to use them. What I discussed here was one simple way to use options for protection.
If you do want to go down the rabbit hole and delve deeper into a more complete and comprehensive study on the subject of options, I highly recommend that you snatch up a copy of Tony Saliba’s book Managing Expectations. He’s one of the best option traders in the world with both the track record and the net worth to prove it.
Everyone knows about the benefits of diversification in your investment portfolio.
Some traders have also heard about the benefits of diversification in your trading systems as well.
Well, I submit the idea that there may be some benefits to be had by diversification in your exit strategies, too.
I mentioned earlier that a trader could use both profit targets and trailing stops. But you can drill down even further and use different kinds of profit targets together and different kinds of trailing stops together.
Perhaps you want to cash out of part of your position when a market tags a Bollinger Band and also take a little off the table when a Fibonacci expansion target is reached.
Then maybe you can trail the stops on the rest of the position via a couple of different moving averages like the 50-day and 200-day and also use a trailing volatility stop like 2 or 3 times the 20-day ATR.
The combinations of what you can do here are endless.
This post and the previous one covered several different ways to exit a trade, from stop losses to profit-taking.
I decided to go wide on the topic instead of deep in order to expose you to a myriad of methods that could be useful for getting out of trades.
One strategy is not necessarily better than the other on its own merit; however, some of them may be a better fit for you than others. Invest the time and test some of these ideas out to discover which strategy or strategies best apply to your trading goals.
But don’t forget that the simple strategies can also be quite potent on their own!
If you find that just one of these exit strategies delivers the results you want, don’t worry about trying to incorporate several different types into your trading if you’re not so inclined.
The most important thing here is that you find a proven exit plan and stick to it.
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