Exits: The Forgotten Component

WHAT SHOULD EXIT STRATEGIES DO?

An ideal exit strategy should exercise strict control over losses while allowing profitable trades to blossom. It should control your risk by quickly exiting from losing trades, but allow winners to mature. It will turn a losing system into a profitable one and can make a profitable system even more so: Your exit strategy will determine whether your system is a winner.

As stated above, a good exit strategy must allow for the:

• Strict control of losses, and
• Maturation of profitable trades.

The most comprehensive exit strategy is one that uses multiple types of exits, which are fitted to the current market environment and your risk tolerance.

DIFFERENT EXIT TYPES

• Profit target: One of the simplest types of exits is one that uses a limit order. This means that if the market moves favorably by a specified amount, the limit is hit and profits are taken.

• Time-based: If a trade lasts more than a specified number of bars/days, it is closed out regardless of profit or loss.
• Signal-generated: An exit based on the use of a technical indicator/oscillator, which issues a notice of an anticipated reversal in the direction of the market.
• Trailing: Normally employed when the trade is progressing in your favor, trailing exits are adjustable stops that you move in the direction of the trend to lock in some of your paper profits. If the market reverses, your trailing stop will cause your position to be closed out while keeping some part of your profit.
• Pivotal juncture: This kind of exit closes your position when the market approaches a critical level such as a moving average, a barrier of support or resistance, a trendline, a Gann line, and so on. If the market moves beyond this point, it would require a reevaluation of market conditions, so you would exit.
• Money management: Closes out a trade at a specified dollar amount of adverse movement. In general, this kind of exit stays in place for the entire time that the trade is on. Although it purports to mitigate your risk, your actual risk may be greater than the predetermined amount, as limit moves or opening gaps could work against you.
• Volatility: This kind of exit recognizes that your risk level is increasing due to rapidly rising market volatility. However, increasing volatility does not suggest a trend reversal. It may only be the precursor of a big move, either friendly or unfriendly. If you think your risk is rising due to higher volatility, it makes sense to close out half of your position. Hence, if the market moves in your favor, you still have part of the trade on. If it moves against you, you have protected part of your profits.

There are many ways to determine where to place such stops, but in the final analysis the simplest is to specify the maximum amount you are willing to risk on any given trade. This can be tricky: If you have a very tight stop, you will be stopped out too often, but if the stop is too loose, you will bear unnecessary incremental loss.

CONCLUSION

Failing to exit at the appropriate time keeps you exposed to the uncertainties of market risk, and that can end up being costly. However, determining the precise moment of exit can be a real challenge. Exiting too quickly risks leaving too much on the table. Staying too long poses the problem of profits becoming losses. Therefore, prior to entering a trade, you should decide when to exit the position using any one of a number of exit strategies. Once you decide when to make that exit, your next challenge is to adhere to your plan.

R.M. Sidewitz is chief executive officer and founder of Qi2 Technologies, LLC, an investment management company, and the managing member of Qi2 Partners LP, a domestic hedge fund. His website is www.cybrlink.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.