Something you will hear me talk about often as a way of communicating my process is defining the different areas of a successful trading strategy. For example it’s my belief that entry is a lot less important than people make it out to be. That’s not to say it’s unimportant, but rather that many people put too much emphasis on finding entries.
Entries don’t determine whether you take a profit or loss on a trade. Exits do. By definition only once you’ve exited can you determine a trade to be a winning or losing one, and position size determines by how much. Your entry setup simply determines how many times you have a position, the frequency of your trades. Of all these I actually believe position sizing to be the most important. But for now let’s concentrate on exits.
When should we exit a position? Ask that question at a trading conference and you’ll get a hundred different answers, many of which may concentrate on the ‘it depends’ angle because we all have different timeframes, objectives, and strategies. I think they’re looking at it the wrong way and it’s possible to define it objectively for all.
Let’s look at some exit methods that many subscribe to.
The fixed percentage loss – No matter what, you take the loss when you’re down by 8%. OK, I understand the need to cut losers, but why a one-size-fits-all 8%? Why not 6%? Or 7%? What if it’s 7.99%? Should I round up? Does that extra 0.01% really change the fundamentals or technical condition of that company? Of course not.
It’s an arbitrary number. It’s good that the need for risk management is recognized but plucking a number from the air is going to make people second-guess when it comes to the crunch. And why have a stop that can be triggered on a daily basis when your methodology for entries is partially based on weekly charts?
What about using profit targets, or price targets as exits? Nope. Don’t even go there, unless you want a job on Wall Street. Think about what placing a price target on a trade is saying. It’s saying:
“I want to limit my gains.”
“This is the most I’m prepared to make on this trade.” (What??!!)
“At this arbitrary point in the future I am predicting my analysis will suddenly be wrong.”
Seriously, if you’re that good at knowing that’s where it all comes undone then maybe you shouldn’t take the trade trying to get there, maybe you should just put in an order to do the opposite if it gets to your target and let that be your trade. Because otherwise it seems to me you’re saying when you enter the trade it could be right or wrong, but when you exit it can only be right, otherwise why exit? Ever notice that? Wall Street research analysts never give you their stop loss, but they always tell you their profit target. That’s messed up. Don’t do that.
So how can we always know our exit at the time we first enter a trade if it’s not necessarily a fixed price, a dollar amount, a percentage, or a point in time? All of those can be factors but they do not define it. It needs to be unequivocal. Here it is:-
YOUR EXIT SHOULD BE THE POINT AT WHICH YOUR ENTRY RATIONALE IS INVALIDATED.
So getting out because you gave back some profit but the reasons you entered are still good, or your P&L hitting a nice round number, no, that’s not gonna cut it, that’s just a way for you to feel better about yourself and avoid cognitive dissonance. You need to get over that, that’s a “my head isn’t straight” exit. Get it straight. Otherwise you’re creating a trading rule based on how it’s going to make you feel. Good luck backtesting that.
If the reasons you bought something still exist but you feel a need to exit based on arbitrary factors then you need to examine those feelings and what basis they really have in your trading, because they’re saying something about you, your mindset and biases rather than your position.
For some this may even bring about the realization they don’t have a robust entry rationale. If you’re trading without one you can’t possibly have a hope of knowing when to get out. If you can define your conditions for an entry you should easily be able to define when those conditions are absent. Don’t allow yourself to get to that place where a ‘trade’ becomes an ‘investment’ because you can’t recognize when you’re wrong.
When your reasons for getting in are invalidated, get out.