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THE OPTIMIZED TRADER


Stop Out

03/31/05 12:08:52 PM PST
by David Penn

What to do when you absolutely, positively have to get out of a trade.

Quick: think of all the different words traders use to describe getting out of a winning or losing position.

"Selling, covering, exiting, punting, taking, bailing, dropping, puking, closing, dumping, ejecting, sh-tcanning, abandoning, liquidating, deep sixing, scratching, unloading, flattening, ditching, bolting... "

The list, as they say, goes on.

Call it what you will, no matter how good a trade is going, no matter how profitable a position may be, sooner or later, the time will come to part ways. And figuring out the best way to get out while the getting is good — or, conversely, getting out before too much more damage is done — is often what makes the difference between consistently profitable traders and those whose great entries only lead to underwhelming (or worse) exits. As William O'Neil wrote in his best-selling book, How To Make Money In Stocks, "The fascinating point is that investors can be good at stock selection because they've studied, worked and acquired the right understanding and experience, but they can also be ignorant about how and why and when to sell their stocks."

I don't know if there are as many ways to exit a market as there are to enter one. But there are a number of techniques, strategies, and tools that traders have used to tell the difference between when it's time to "hold 'em" and it's time to "fold 'em." In fact, some observers have remarked that exits are even more important than entries when it comes to short- and intermediate-term trading. "Give me a random entry," goes this line of thinking, "sound money management and an exit strategy, and I'll give you a winning trade more often than not."

Whether or not you endorse this view in your own trading, this kind of opinion does underscore the importance of having an exit strategy — and that even a flawed exit strategy is likely to be better than having no exit strategy at all. So, given the myriad ways of, ahem, getting out of a position, how does a trader go about finding which works best for his or her trading style and psychology?

ABSOLUTE STOPS

The simplest stops are "line in the sand" stops based on a certain target price, price movement, or percentage movement. One of the most familiar (and best) of these absolute stops is embedded in the exit strategy advanced by William O'Neil in How To Make Money In Stocks. In the section titled, appropriately enough, "When To Sell And Take Your Profit," O'Neil lists 36 "other prime selling pointers" and an additional eight tips on "when to be patient and hold a stock." But what most readers have taken away from O'Neil's work on the subject is his famous axiom to "take 20% profits when you have them (except with the most powerful of all stocks) and cut losses at 8%."

What's so special about 20% up and 8% down? Here's O'Neil's explanation:

"In summary, here was the revised profit-and-loss plan... The plan had several enormous advantages. You could be wrong twice and right once and still not get into financial trouble... Also, you were utilizing your money in a far more efficient manner. You could make two or three 20% plays in a good year, and you did not have to sit through so many prolonged, unproductive corrections in price while a stock built a new base for many months."

So, while there is nothing magical about the 20% profit/8% loss limits, they do embody many of the most fundamental tenets of trading, such as letting profits run and cutting losses short.

Some shorter-term traders have had a difficult time sticking with O'Neil's formula. Swing traders and daytraders in particular — as well as many futures traders — who like the certainty of absolute stops also tend to prefer to work more with specific price targets than with an exit strategy based on percentage gains and losses. In fact, many shorter-term traders — compared to O'Neil's position traders and investors — are more than willing to trade occasional large-scale 20% gains for frequent, small-scale 5% gains. As Oliver Velez, swing trader and founder of Pristine.com, once suggested to an audience at one of his trading seminars, the professional trader (the "master trader" in Pristine phraseology) would rather have nine out of 10 winning trades that produce a gain of 75 cents each than seven out of 10 that produce a $1.00 gain, or five out of 10 that yield $1.35 each.

While Velez was speaking specifically about the advantage of being consistently profitable — even if the actual profit amount appears relatively low on a trade-for-trade basis — his point introduces the preference many traders have of being able to hit a certain amount of profit consistently. Are these traders losing out by not letting their profits run? Are they leaving too much money on the table?

Figure 1: This 30-minute chart shows one of the downsides of absolute, or fixed profit, stops as an exit strategy. A daytrader with an absolute profit stop of only a few points may have missed out on the full profit potential of the market's collapse in the final few hours of trading on March 22.

Here's what Van K. Tharp, author of Trade Your Way To Financial Freedom, has to say about fixed-profit stops.

"If you are managing other people's money, it is more important to minimize drawdowns than it is to produce large returns. As a result, you might want to consider exits that keep you from giving back too much profit. For example, if you have open positions on March 31 that put your client's account up 15 percent in his March statement, then that client is going to be upset when you give back much of that profit. Your client will consider that open profit to be his money."

That client is likely not to be the only one who might feel that way. I daresay that one thing that drives traders who don't use fixed-dollar profits crazy is having a market that has been generous suddenly turn stingy and then greedy as it races to take back the gains it has given. With a fixed-dollar profit (for example, 2 points a day per contract in the emini S&Ps), the objective is fixed and once the trader reaches that objective, the "campaign" is successfully concluded. Here, the trader isn't worried about "leaving money on the table" because he or she is confident in his or her ability (or system's ability) to produce the 2 points per contract every day.

Not only is this approach popular among many daytraders, but it is also the method many undercapitalized traders pursue, with an eye toward building up an account size steadily and slowly with small gains but even smaller losses. As Tharp notes elsewhere, there is a psychological comfort involved in these sort of stops, inasmuch as they let a trader know precisely how to measure success (and risk) in every single trade.

How can absolute stop points be determined? One rule of thumb is that if a trader is shooting for a 3:1 reward to risk ratio, then the absolute exits should be located correspondingly. Victor Sperandeo talks about using reward to risk ratios as a guide in both trade and money management in his book, Principles Of Professional Speculation:

"As a general rule, I use a 3:1 reward-to-risk ratio as a minimum requirement for involvement in any trade. In other words, I enter a position only if the odds... point to a minimum upside potential three times greater than the maximum downside potential. In addition, in the early stages of a new accounting period, I risk only a small fraction, at most 2 or 3 percent, of available capital in any position, regardless of the reward potential... "

Some traders blend this approach with the relative trailing-stop methods discussed below. For example, a trader may begin using a trailing highs/lows stop after the 3:1 reward-to-risk threshold is reached in order to maximize gains during a strong trend or runaway market. Interestingly, because Sperandeo prizes preserving capital above "making money," he stresses consistent profitability as more important even over "pursuing superior returns" — which ranks third on his list of what he calls "the fundamental principles of a sound investment philosophy" (third behind "preservation of capital" and "consistent profitability").

Why so? As he writes: "Limit your risk, retain a portion of each gain, and profits will accrue. Once you reach a comfortable level of profitability, you can begin to pursue superior returns." Fortunately, there are a variety of techniques and tools to help traders to do just that. And as far as stops are concerned, the more flexible or relative stops discussed next can be very much a part of that toolbox.

RELATIVE STOPS

Relative stops such as the various trailing-stop methods used frequently by traders and investors definitely help with the "keep your losses small" half of the trader's profit/loss maxim — but what they really provide traders with is the opportunity to "let profits run." While it is of ultimate importance that traders keep their losses to a minimum, it is only of slightly less importance that traders maximize their gains when they have them. To this end, trailing-stop methods can help a trader stay in a trade long enough to reap the benefits of a solid trend without exposing the trader to too much risk of loss in the event of a reversal.

Writing about trailing stops, John Hill, George Pruitt, and Lundy Hill, the authors of The Ultimate Trading Guide, suggest:

"Trailing stops offer the best method of taking profits. A trailing stop will follow a market and lock profits in at certain levels. Many times a trending market will retrace a certain percentage before it continues in the initial direction of the trend. Trailing stops give the markets room to gyrate, before taking a profit. These types of stops do not limit the big winners as does the profit objectives."

If there is a downside to trailing stops, then it is that trend traders tend to have better luck with them than do swing or daytraders. Why? Swing and daytraders are often focused on capturing small, certain gains — such as the emini daytrader who looks to take an average of a few points a day out of the market. For these traders, it is often more advantageous to take the "few points" as soon as they appear, rather than risk giving back some of that gain with, for example, a trailing-lows stop. Again, the goals of the trader are crucial. The short-term daytrader who looks to extract a few points a day, every single day, will have a different attitude about the amount of "give back" his or her system can stand compared to a swing trader who needs more room in order to let his or her trades reach their objective.

That said, what are some of the more common trailing-stop techniques that traders have used effectively?

The most common is probably the trailing-highs/trailing-lows method. Using trailing stops like this simply requires that the trader who is long keep track of the subsequent lows — which, in an ideal world for the long trader, will be higher and higher as the trade progresses. For this trader, a stop is placed under the low of the preceding bar or candlestick. When the market makes a significant-enough lower low instead of a higher low, the trader is stopped out automatically. The same thing works for the short trader: actual or mental stops are placed just above the high of the previous bar or candlestick. When the market that has been moving lower then makes a higher high (instead of the string of lower highs that had hopefully been guiding the market lower), the short trader covers his position.

Figure 2: Here, it is the trailing stop that proved to be the trade's undoing. Short by virtue of a negative stochastic divergence and moving average convergence/divergence histogram (MACDH) reversal to the downside, the trade that was triggered on March 8 and filled on March 9 was stopped out on March 11 because of a too-tight trailing stop. Painfully, the market moved significantly and sharply lower shortly thereafter.

There are variations on the trailing-stop technique. Some traders use a short-term moving average of closes or highs/lows rather than the actual highs or lows themselves. When the price regresses to the moving average, the trade is stopped out. Still others use moving average crossovers — the same kind of moving average crossovers used to enter trades — as a signal that the trend has reversed and an exit is deemed important to preserve gains and limit losses.

In addition to these price-based relative stops, there are also time- and volatility-based relative stops. These methods work by using some variable — the passage of time or the oscillation of price — to determine when risk has shifted against the trade. Time-based stops are among the least frequently considered by many traders. But this is perhaps to their detriment — especially if they are shorter-term traders. In fact, the time-based stop might be one of the few "relative" stops that work especially well for traders operating from an abbreviated time frame. As Mark Fisher wrote in his book The Logical Trader:

"Too many traders focus only on price, and not enough on time. In other words, when plotting out your trade, it is not only if a price level is reached but how long the market spends there. The vast majority of traders I know trade on price, but not on time. How many people have you heard say that if you take a position and it doesn't go anywhere in 20 or 30 minutes, then you should get out? Very few, if any. I'm here to state that time is the most important factor in trading. If the scenario you've envisioned doesn't materialize within a certain time frame, then just move on and look for the next trade."

Traders in futures and options — as well as daytrading oriented traders such as Fisher — are perhaps more sensitive to the play of time than are other traders. Indeed, Fisher's words have been echoed by traders like Price Headley, whose time frame is longer than Fisher's, but is nevertheless equally informative when it comes to "timing out" trades. Though particular to options trading, Price Headley's observations in Big Trends In Trading are perhaps instructive to all traders. He suggests that:

" if you have not seen the options you bought move up by 20 percent or more within three trading days to no more than five trading days, then the market has not proven you correct in your timing. Not only do you risk the negative effects of time decay if you hang on in hope that the position will get moving, but you also have an opportunity cost that causes you to miss out on better options movers elsewhere."

I've heard this sentiment expressed by stock traders like Gary Smith of Real Money who encourages traders to think of their capital as inventory, as well as at least one institutional money manager. The latter referred to the way that a new piglet will nudge another out of the way while trying to nurse when describing his process of replacing unprofitable or laggard positions with new opportunities.

Volatility-based stops are actually more common than they may seem — being the basis for exit strategies that rely on, for example, the average true range (ATR). In fact, one of the more popular stop-loss, trailing-stop techniques among some trend traders in recent years has been the chandelier stop. Popularized by Chuck LeBeau, the chandelier stop uses past highs to help traders in new long positions and past lows to help traders in new short positions. As LeBeau wrote in a bulletin for The Trader Club Forum in 1999:

"The Chandelier Exit hangs a trailing stop from either the highest high of the trade or the highest close of the trade. The distance from the high point to the trailing stop is probably best measured in units of Average True Range. However, the distance from the high point could also be measured in dollars or in contract-based points."

Even here, however, LeBeau and co-author Terence Tan observe that for some traders, the ATR basis of the Chandelier exit might lead to losses or premature exits in tight markets with exceptionally narrow ranges. In addition, some have shied away from the Chandelier exit because of the potential of "give back," as discussed previously. As such, trend traders, who are far more interested in the "meat in the middle" of a trade than they are with trying to capture the last point or tick, have especially prized exits like the Chandelier.

STOP SIGNS

How do traders and investors know which stop is for them? Deciding how to get out of a trade — or, to be more accurate, how you will let the market take you out of a trade — is as much a function of trader or investor psychology as it is of methodology. After all, the best strategy in the world will be of little help to the trader or investor whose nerves are shot trying to follow it.

Price Headley offers one rule of thumb that might be helpful for traders and investors who, while still perhaps not knowing exactly what kind of stops they want to use and when, nevertheless realize the importance of stops and exit strategies that are compatible with who they are as human beings as well as who they are as traders and investors. Headley, whose book is largely an ode toward taking maximum advantage of maximum trends, writes:

"Should we use a fixed target, or should we only use trailing stops on winning positions until the trend breaks? The answer depends on your risk tolerance. For conservative traders, I recommend sticking with price targets compared to defined risk levels, as you can lock in profits more safely that way. For more aggressive traders I usually recommend taking half of the position off at a price target, and then tightening your trailing stop to the breakdown of a fast moving average, like a five-day moving average. That way you give yourself a chance to stay with a winning stock, while keeping the profits given up from your initial target level to a minimum."

It is hardly surprising that Headley's advice involves a combination of factors and a combination of stop techniques. It is also entirely possible for a trader trading multiple accounts to treat these accounts differently with regard to exits. The trending markets of foreign exchange, for example, might be more profitably traded using trailing stops (especially on the daily charts), whereas when that same trader switches to his or her daytrading, emini S&P screen, it may be simply a matter of exceptionally tight stops and 2-3 points per day goals. As always, the point in trading is a combination of strength and flexibility: strength to stick with a disciplined and consistent method, and flexibility to apply that method — or another one — as the conditions of the market demand.

And, as it is in trading, so it is with the inevitable stopping out.

David Penn may be reached at DPenn@Traders.com.

SUGGESTED READING

Elder, Alexander [2002]. Come Into My Trading Room, John Wiley & Sons.
Fisher, Mark B. [2002]. The Logical Trader, John Wiley & Sons.
Headley, Price [2002]. Big Trends in Trading, John Wiley & Sons.
Hill, John R., George Pruitt, and Lundy Hill [2000]. The Ultimate Trading Guide, John Wiley & Sons
LeBeau, Chuck, and Terence Tan [1999]. "Trailing Stops — The Chandelier Exit," Traders Club Bulletin 35. Trailing Stops, The Trader Club Forum. December 3.
Nassar, David S. [2001]. Rules Of The Trade, McGraw-Hill.
O'Neil, William J. [1995]. How To Make Money In Stocks, McGraw-Hill.
Sperandeo, Victor [1994]. Trader Vic II — Principles Of Professional Speculation, John Wiley & Sons.
Tharp, Van K. [1999]. Trade Your Way To Financial Freedom, McGraw Hill.
Velez, Oliver, and Greg Capra [2000]. Tools And Tactics For The Master Day Trader, McGraw Hill.

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





David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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