People spend a lot of time thinking about how and when to enter a trade. However, how you exit a trade is probably even more important. In this article I focus on how improving your trade exits can increase the profitability of your strategies.
In this article I analyze the affect of two different strength exits on a trend following strategy. See the video below for more information.
A Trend Following Strategy
I started my analysis with a trend following trading strategy. This strategy uses a 200 period linear regression line to identify the dominant market trend. When the linear regression line is pointing upwards the strategy trades long. When it is pointing downwards the strategy trades short.
The strategy then enters trades on a short-term retracement using a limit order. The retracement is calculated based on the past 20 periods.
The attached chart shows an example of a long trade. The linear regression line is pointing upwards and the market has made a retracement from a short-term high.
The basic form of this strategy has no stops or profit targets. It is always in the market and only changes direction when a trade is opened in the opposite direction.
Exit Trades on Strength
In this article I am referring to market strength to mean strongly upwards for a long trade and strongly downwards for a short trade.
The classic trading adage is, “Cut your losing trades and let your winning trades run.” This is a useful rule of thumb, however it does not apply to all trading situations. Different strategies, different markets and different timeframes need different approaches. As traders we may need to adapt our approach for every trading strategy we use.
Stop-losses are an example of exiting the market on weakness. They are triggered when the market is moving against our trading position. They have the potential for negative slippage.
Stop-losses are a very useful tool for traders. They are important in analyzing a trading strategy because they give us a maximum potential loss. This means that we can calculate the amount of our portfolio to allocate to the strategy. However, there are problems with using stops. Apart from the difficulty of where to put them, one of the biggest problems is that in extreme situations, markets can gap through stop-losses. This means that we can end up with a much larger loss than we expected.
Profit targets are an example of exiting the market on strength. They are triggered when the market is moving in the direction of our trading position. They have the potential for positive slippage.
The profit target I am using in this analysis is calculated based on the ATR. This means that the profit target reacts to volatility and will be larger during volatile periods and smaller during quiet periods.
The Strength Exit
There are many other ways to exit the market on strength. In this article I am going to compare profit targets with what I am calling the Strength Exit.
This exits after the market moves a set number of bars in the direction of the trade. Each bar must close a minimum percentage higher (or lower for short trades).
In the chart image you can see how the system counts consecutive green bars (for long trades) greater than a set size.
Trading Strategy Analysis
Tradinformed Backtest Models
The analysis shown in this example was calculated using a Tradinformed Backtest Model. These are a way that anyone with some Excel skills can test their own trading strategies. They can be used on all timeframes and all markets. To find out more, see this description of the Tradinformed Backtest Models.
Trading Strategy Analysis
I tested the strategy using the S&P 500 Index on the daily timeframe. I tested from 1990-2016. I tested the strategy using a 30% retracement.
The profit target was calculated as 5 * ATR.
The Strength Exit was based on 5 bars in the direction of long trades, 2 bars in the direction of short trades. Long trade bars had a minimum gain of 0.5% and short trade bars had a minimum gain of 0.25%.
|No Exit||Profit Target Only||Profit Target and Strength Exit|
|Gross Winning Trades||$746,169||$1,268,756||$1,855,394|
|Gross Losing Trades||$-165,296||$-548,658||$-692,999|
|% Winning Trades||56%||82%||76%|
|Average Winning Trade||82,908||18,937||16,566|
|Average Losing Trade||-23,614||-36,577||-19,250|
|Largest Winning Trade||$235,644||$44,698||$66,369|
|Largest Losing Trade||$-48,226||$-93,581||$-134,757|
The above results show that using a profit target and Strength Exit showed a significant improvement in this trading strategy.
I think the Strength Exit shows good potential to be used in other types of trading strategy. One way that I am going to make it more adaptable is to use different exits when a trade is in profit compared to when it is in loss.
It is often easier to watch rather than read. Check out the accompanying video for further information.