BarroMetrics Views: Exiting Trades
I received an e-mail from a John Stewart asking why I exit positions even if my stop has not been hit. That’s an answer worthy of a blog.
There are a number of strands to the answer:
- It starts with my trading philosophy and
- The best way to implement it.
- We then consider the specific implementation modes.
My trading activities have one dominant tenet: preservation of capital. If I were given a choice of making 15% per annum with single digit drawdowns and 100% per annum with 50% drawdowns, I’d opt for the former. So, with that as my starting point, how do I implement it nowadays.
Three ideas play a central role:
- The Expectancy Return Formula
- The ideas of Pete Steidlmayer and
- The ideas of the Phantom of the Pits. (Click on the link to download his free e-book).
The Expectancy Return Formula:
(Avg$Win x WinRate) – (Avg$Loss x Loss Rate)
shows what is required to sustain our long-term profitability. Aiming for a high win rate alone is not enough – we may have large losses and small profits; aiming for a large average dollar win is not enough – our dollar win may not be profitable often enough; the key is found in the interaction of all four factors.
For my own trading, I have found that I can have a great bottom line with a hit rate of around 48% to 52% and when my losses are less than 1/3 of my profits. To do this, I rely on Pete’s and the Phantom’s ideas.
Peter taught that trades are best managed structurally i.e. you enter a trade with a scenario in mind. That scenario has certain benchmarks that should and should not unfold. If the latter occurs or if the reasons for the trade are no longer valid, then you exit the position.
To Pete’s ideas, I add a price-stop: i.e. a price beyond which I am not prepared to accept more losses irrespective of my view of the structure.
The idea that I took from the Phantom was: we exit trades if the market fails to prove our trades right within a certain time. In effect this means a ‘time stop’. Note that this is different to the ‘price stop’ philosophy where you exit because the market has proved you wrong.
I have a time stop for my setups – these I obtained by analysing my results and in particular noting the relationship between setups, holding period and result. The length of time I’ll hold a position will be dependent on the instrument, context and setup.
So, I have three initial exit strategies:
- Structural (most common exit when trading well)
- Price (most common exit when trading poorly)
On Monday I’ll illustrate the ideas with a recent trade that I shared on the Forum and Twitter.