Getting Back To Basics - A Trading System And Its Exit Rules

(c) Dean Whittingham 2008

In my last article I spoke about getting back to the basics of trading when you find yourself struggling. I also mentioned that it was not the complete picture and that an exit strategy is more a function of the trader themselves. In this article I explain why.

There are many ways to formulate an exit strategy. Other than an initial stop loss, which is there to get you out of a bad trade, exit strategies are used to achieve a goal. A lot of traders don’t understand this concept and therefore pay little attention to it, spending more of their time worrying about entries.

Those that do consider the exit strategy important may still place more importance on finding the exit strategy that proves to be the most rewarding when back-testing. Although this is important it is only half the picture. An exit strategy also needs to support you the trader and help you achieve your goals.

An example: The three most popular methods for exiting a trade are to use profit targets, trailing stops, and indicators; some people may even use a combination. If you use a profit target as an exit strategy, there must be a reason. A long term investor, or someone who trades medium to long term has less need for profit targets and more need for catching trends; therefore trailing stops are more suited.

Someone who uses profit targets is more likely to be shorter term, someone looking to use the markets to generate income, or even be a novice looking for consistency to build confidence. You see if your goal was to generate some sort of long term result such as a decent return on your capital over 5 years, then profit targets are a waste of your valuable time. What you need is to catch trends, and an exit strategy that uses profit targets is not going to allow you to do that, because you never know how long the trend will last.

If you take the time to assess what it is you want from your trading, you’ll find that the exit strategy you employ is either going to fit or it isn’t. If your shorter term and looking for income, what’s important to you is knowing what your goal is for the week or month, knowing your average win to loss ratio, knowing your average profit to loss ratio, and setting profit targets based on that.

For example, if your goal is to generate $1000 a week from trading and your system has a 60% win to loss ratio, and you always set your profit target to the same as your risk (this means you have a 1:1 profit to loss ratio per trade), then each trade would have a $500 risk, and a $500 profit target. Let’s do the math here…

10 trades; each trade we risk $500, and we set a profit target of $500 (after commissions). We have 6 winners totaling $3000 profit. We have 4 losers totaling $2000 loss. Result - $1000 profit. In this situation, your exit strategy has helped you to achieve your goal.

Now let’s say you didn’t understand the concept of exit strategies and thought that the best way to exit your trades was to use trailing stops. This is fine if your goals are longer term, but if your goals are to create income, or even to create confidence in yourself as a trader, then using trailing stops takes away any short term certainty; something that you need if looking to generate income or gain confidence.

Let’s look at longer term exit strategies. If your goal is to build your wealth over a certain period then your more than likely looking to catch trends; the reason is because at any given time, some market some where is trending.

The Turtles made a name for this sort of strategy where their goal was not some monetary figure every month but merely to make sure they caught every trend that presented itself. In order to do this, they had to employ the right exit strategy. See how I said exit strategy and not entry strategy. Although important, the entry was merely a set of rules that ensured the Turtles entered every market that looked like it could trend, even if no trends eventuated for many months. The exit strategy was the system that allowed those markets that did trend to pay handsomely. One trending market was all it took in one year to more than offset all the many losses, and return a profit that most fund managers would frame and place on their walls.

The actual exit strategy the Turtles used is not the point; the point is to find a strategy that suits you and your goals. Worrying about whether to use a trailing stop, or a volatility stop that works out some weird percentage of the daily range, or even some indicator cross over is fine if you’re longer term, but most traders are not long term and so must pay special attention to their goals and what they are trying to achieve.

I firmly believe that all exit strategies if tested over a long enough periods will produce similar results. It’s how practical they for you and your trading business that is more important.

My suggestion is to assess where you are. If you’re looking for short term results such as income, use profit targets. If you’re new or even struggling, but are not too concerned with income right away, using a profit target is still the better option as it helps you build confidence. Only move to the longer term exit strategies such as trailing stops once you have gained confidence in yourself to let trades run, and have less need for the income.