Exits are the Key to Making Money

As I mentioned in the last tip, I decided to prove to myself that one could make money with random entry. I designed a system that traded 10 commodities over a ten year period. It was always in the market on all ten positions so that when it exited, you had to reenter long or short, based upon a coin flip. I also added $100 in for slippage and commissions for each position, so I had to overcome a huge potential trading cost plus the fact that my entry was random.

Now when you think about the idea of random entry, you are giving up any advantage that your particular edge has. The only way you can possibly make money is to occasionally catch a strong trend and make sure that your losses are not too big and that you practice proper position sizing.

How can you your exits help you catch a strong trend? Well, in a random entry system the first thing to consider is that when you exit, you'll enter back into a trade again and lose another $100 for slippage and commissions. Thus, you want your initial exit to be large enough to make sure that you don't exit very often. At the same time, you don't want to enter into a trend in the wrong direction, which would cause you to pile up huge losses. Thus, to make the random entry system work, I needed an initial stop that was big enough to keep me in the market while it was just making random noise type movements or moving sideways. And one such exit is three times the 20 day volatility or average true range.

I also like simple, so I made the abort exit and the profit taking exit very similar. I simply trailed three times the (20 day) average true range from the closing price. Thus, if the price moved in my favor, so did the trailing stop. And if the volatility shrank, then the stop also would move in my favor.

As a result of this exit, 1) I was able to stay in sideways markets a long time and not get stopped out; 2) if I entered against the trend, I was stopped out quickly and hopefully the random enter would re-enter in the direction of the trend, and 3) if I was lucky enough to enter in the direction of the trend, then my stop kept me in the trend for a long time. It was that easy. And with that simple exit the random entry system was able to follow the golden rule of trading (cutting losses short and letting profits run) and thus make money overall.

Chapter 10 of the new edition of Trade Your Way to Financial Freedom deals with the abort type exit (i.e., your initial stop) in great detail. When you think about this exit, what it is designed to do is define what 1R is for you.

In reality, there are two kinds of stops - tight stops meaning that 1R is small, and wide stops meaning that 1R is big. Each of these has some distinct advantages. The wide stop keeps you in a trade for a long time and gives it a chance to start working for you. Thus, if you like to be right, you have more of a chance with a wide stop. Examples of this might be the three times volatility stop just mentioned for the random entry system and a 25% retracement stop which works fairly well for equities.

The other type of stop is the narrow stop which defines 1R as a very small amount. If you want to be right, then you don't want this sort of stop because you'll be stopped out a lot. However, if you want large R-multiple gains, then you'll find some advantage to tight stops.

Let's look at an example, suppose you buy a $50 stock when it breaks out from a consolidation with power. If you put your stop below the consolidation, say at $45, then you'll probably be right a lot. However, if the stock goes up $10 in price, you will have only made twice your risk or 2R.

But suppose you put your stop in at $49, a dollar away. If the move has power behind it, then the stock should keep moving and you won't be stopped out. Furthermore, if the stock goes up $10, you've now made a 10R profit or 10 times your initial risk. In fact, you could be stopped out 3 times in a row, getting three 1R losses, and then make your 10R profit. You are only right 25% of the time, but your total profit is 7R.

Setting your initial stop loss totally helps you define the R-multiple distribution that your system will generate. There are a lot of complex issues involved, beyond those just mentioned, so I recommend that you take a look at chapter 10 of the new edition of Trade Your Way to Financial Freedom.

Dr. Van K Tharp
TradingEducation.com

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