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Exit Tests

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Exits for All Occasions


When most people think about trading systems, they probably think about how the system enters the market. In fact, trading systems are usually described in terms of their entry technique, such as breakout systems, moving average crossover systems, Fibonacci retracement systems, and myriad other methods for entering the market. Even the terms "counter-trend" and "trend-following" refer more to the entry than the exit.

Despite the common focus on entry techniques in trading, you may have come across the assertion that exits are more important than entries. In my experience, that's usually true. Why? One possible reason is that most market action is random. A good trading system finds at least some signal in all that noise. But with all the noise in the market, a substantial percentage of entry signals may be wrong.


A long-term trend following system, for example, may be right only 40% of the time. Despite the low percentage of winning trades, it can still be highly profitable if it keeps the losing trades smaller than the winners. The way it does that is by cutting the losses short and letting the winners run. In other words, it's profitable because of how it handles the exits.


Generally speaking, I think it's fair to say that exits are the principal method of controlling the intrinsic risk/reward characteristics of a trading system. Whether the system looks for a quick profit or holds the trade through the market's ups and downs depends on the exits. Likewise, whether a losing trade is cut off quickly or given more room to move is determined by the exits. Exits are truly the way to implement "cut your losses short and let the winners run."


Note that I use the word "intrinsic" when describing the risk/reward characteristics of a trading system to differentiate the rules and logic of a trading system from position sizing. Certainly, position sizing can be used to improve the overall risk/reward ratio of a trading system, but position sizing is an external factor, apart from the rules and logic of the system. The focus of this article is on the rules and logic of trading systems, rather than on position sizing.


Exit Types


The following list is not exhaustive but it includes some of the most common types of exits you may encounter or consider for your own trading systems:


Stop and Reverse. This is basically an "exit-less" exit. Stop and reverse systems reverse from long to short and back to long again. If you're long one contract, for example, you would sell two to close out the long trade and go short. You're never flat the market with this type of exit because each exit is also an entry in the opposite direction.


N Bars from Entry. Exit the trade at the market N bars from the bar of entry, where N can be any number greater than zero. For example, you might exit the trade 10 bars from the entry. The duration of the trade will depend on the bar size; e.g., 5 min bars or 60 min bars.


Time of Day. Rather than exiting relative to the entry, as with the previous method, you exit at a specific time of day, such as at 10:30 am. As a special case, this exit also includes exiting at the end of the trading session.


Money Management Stop. This is a commonly used exit type that uses stop orders to limit the risk of a trade. For a long trade, a sell stop order is placed below the entry price. For a short trade, a buy stop order is placed above the entry price. When the stop is hit, the loss is limited to the size of the stop plus slippage. Common methods on which to base the size of the stop are a fixed dollar amount, a fraction of the average true range, or as a percentage of price.


Trailing Stop. This type of exit uses stop orders to lock in a percentage of the open profit after a specified level of open profit -- the floor -- has been reached. For example, after an open profit of $500 has been reached on a long trade, you might place a stop order below the market so that 50% (or $250) of the open profit will be retained if the market reverses. The floor amount is typically computed based on either a fixed dollar amount or a fraction of the average true range. Note that a breakeven stop is a special case of the trailing stop where the percentage of profit to lock in is zero.


Profit Target. The profit target uses limit orders to exit when a specified price has been reached, representing a profit for the trade. For a long trade, the limit order is above the market; for a short trade, it's below the market. Like a trailing stop, a profit target can help avoid giving back open profits when the market reverses. However, profit targets also place a limit on the maximum profit that's possible from a trade.


Logical conditions/trading logic. In addition to the exit types listed above, just about any logical condition, such as those used for trade entries, can be used to exit a trade.


Price Patterns. For example, a series of consecutive lower closes might be used to exit a long trade.

Trend Indicators. For example, moving averages, momentum, and MACD could all be used to signal a trade exit.

Trend Strength. For example, when the ADX indicator, which measures trend strength, declines below a certain level, a trend-following trade might be exited.

Oscillators. Stochastic, %R, RSI, Bollinger bands, and other oscillators measure over-bought and over-sold conditions. A long trend trade might be exited when an oscillator crosses below the over-bought level, indicating the end of an up-trend. On the other hand, if the trade has been entered on weakness, such as a pull-back, a short-term trade might be exited when the oscillator crosses above the over-bought level.

Support/resistance. Support and resistance levels can be used either as money management stop prices or as target prices



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