The following article was originally published in the December 2007 issue of The Breakout Bulletin.
 

Exits for All Occasions 

When most people think about trading systems, they probably think about how the system enters the market. In fact, trading systems are usually described in terms of their entry technique, such as breakout systems, moving average crossover systems, Fibonacci retracement systems, and myriad other methods for entering the market. Even the terms "counter-trend" and "trend-following" refer more to the entry than the exit.

Despite the common focus on entry techniques in trading, you may have come across the assertion that exits are more important than entries. In my experience, that's usually true. Why? One possible reason is that most market action is random. A good trading system finds at least some signal in all that noise. But with all the noise in the market, a substantial percentage of entry signals may be wrong.

A long-term trend following system, for example, may be right only 40% of the time. Despite the low percentage of winning trades, it can still be highly profitable if it keeps the losing trades smaller than the winners. The way it does that is by cutting the losses short and letting the winners run. In other words, it's profitable because of how it handles the exits.

Generally speaking, I think it's fair to say that exits are the principal method of controlling the intrinsic risk/reward characteristics of a trading system. Whether the system looks for a quick profit or holds the trade through the market's ups and downs depends on the exits. Likewise, whether a losing trade is cut off quickly or given more room to move is determined by the exits. Exits are truly the way to implement "cut your losses short and let the winners run."

Note that I use the word "intrinsic" when describing the risk/reward characteristics of a trading system to differentiate the rules and logic of a trading system from position sizing. Certainly, position sizing can be used to improve the overall risk/reward ratio of a trading system, but position sizing is an external factor, apart from the rules and logic of the system. The focus of this article is on the rules and logic of trading systems, rather than on position sizing.

Exit Types

The following list is not exhaustive but it includes some of the most common types of exits you may encounter or consider for your own trading systems:

Stop and Reverse. This is basically an "exit-less" exit. Stop and reverse systems reverse from long to short and back to long again. If you're long one contract, for example, you would sell two to close out the long trade and go short. You're never flat the market with this type of exit because each exit is also an entry in the opposite direction.

N Bars from Entry. Exit the trade at the market N bars from the bar of entry, where N can be any number greater than zero. For example, you might exit the trade 10 bars from the entry. The duration of the trade will depend on the bar size; e.g., 5 min bars or 60 min bars.

Time of Day. Rather than exiting relative to the entry, as with the previous method, you exit at a specific time of day, such as at 10:30 am. As a special case, this exit also includes exiting at the end of the trading session.

Money Management Stop. This is a commonly used exit type that uses stop orders to limit the risk of a trade. For a long trade, a sell stop order is placed below the entry price. For a short trade, a buy stop order is placed above the entry price. When the stop is hit, the loss is limited to the size of the stop plus slippage. Common methods on which to base the size of the stop are a fixed dollar amount, a fraction of the average true range, or as a percentage of price.

Trailing Stop. This type of exit uses stop orders to lock in a percentage of the open profit after a specified level of open profit -- the floor -- has been reached. For example, after an open profit of $500 has been reached on a long trade, you might place a stop order below the market so that 50% (or $250) of the open profit will be retained if the market reverses. The floor amount is typically computed based on either a fixed dollar amount or a fraction of the average true range. Note that a breakeven stop is a special case of the trailing stop where the percentage of profit to lock in is zero.

Profit Target. The profit target uses limit orders to exit when a specified price has been reached, representing a profit for the trade. For a long trade, the limit order is above the market; for a short trade, it's below the market. Like a trailing stop, a profit target can help avoid giving back open profits when the market reverses. However, profit targets also place a limit on the maximum profit that's possible from a trade.

Logical conditions/trading logic. In addition to the exit types listed above, just about any logical condition, such as those used for trade entries, can be used to exit a trade.

A Comparison Study

To test and compare different exit types, a simple system was written in TradeStation's EasyLanguage. The system, called ExitTests, is available on my downloads page. ExitTests enters trades using a 20-bar channel breakout: it buys at the highest high of the last 20 bars plus 1 point on a stop and sell short at the lowest low of the last 20 bars minus 1 point on a stop. Channel breakouts tend to work fairly well as trend following systems.

The following exits were tested:

1. Stop and reverse.

2. 20 bars from entry.

3. Money management (MM) stop: size equal to 1 x average true range (ATR) of the last 20 bars -- ATR(20).

4. Trailing stop: floor at 1 x ATR(20); 50% profit lock.

5. Target: 1 x ATR (20) from the entry.

6. Moving average: exit long when close is below moving average (MA) of last 20 closes -- MA(20); exit short when close is above MA(20).

7. RSI: exit long when RSI of the last 14 closes -- RSI(C, 14) -- crosses above 70; exit short when RSI(C, 14) crosses below 30.

In addition, the following combinations of exits were tested:

1. N bars with trail

2. N bars with target

3. N bars with MA

4. N bars with RSI

5. MM stop with trail

6. MM stop with target

7. MM stop with MA

8. MM stop with RSI

The same parameter values were used for all tests and all markets. These values, as listed above, were not optimized.

Each exit was tested over the following five futures markets: crude oil (CL), E-mini Russell 2000 (ER2), Japanese Yen (JY), T-bonds (US), and wheat (W). The test period was 20 years of daily data where available (six years for the ER2), and no commissions or slippage were deducted. The tests were conducted in TradeStation 8.2.

The results are shown in the following figures. The corresponding Excel spreadsheet is available online on my downloads page.

Fig. 1. Exit test results for 20-bar channel breakout system, single exit types.

Fig. 2. Exit test results for 20-bar channel breakout system, combination exit types.

The figures display the net profit (Net Prof), worst-case drawdown (DD), and profit factor (PF) for each market and exit type. The best exit type for each market is highlighted in green, and the worst exit type is in red. The best and worst were chosen subjectively based on a combination of the three performance metrics (profit, drawdown, profit factor).

It's apparent from the figures that there is no consistently best exit type. In fact, each market has a different best exit type. This suggests that it may make sense to customize the exit rules to the market. However, for some systems, such as long-term trend-following systems, the number of trades from one market may be too small for statistical significance. In that case, it may be necessary to use the same rules for all markets.

Overall, the combination of N bars from entry with a profit target ("NB-Targ") was the best exit, as judged by average net profit and average net drawdown. The advantage of exiting at N bars from entry is that the exit is unaffected by market volatility. It acts as a way to get out of a trade that isn't working. It makes sense that this works well with a profit target. This combination is basically saying "either we hit our profit goal within N bars or we get out."

The worst exit, somewhat surprisingly, was the combination of a money management stop and a profit target ("MM-Targ"). This combination was worse than either the money management stop or the profit target by itself. The reason for this is that the profit target was relatively small and the same size as the stop. This resulted in a large number of small trades, many of which were stopped out. Without the profit target, the trades were much longer in duration, and the profits were larger. This illustrates that when a money management stop and a profit target are combined, they have to be sized relative to each other. In this case, because the channel breakout method typically has less than 50% profitable trades, it would be better to increase the size of the target relative to the stop so that the average winning trade is larger than the average loss.

Among the single exit types, the best overall was the target exit, which was also the most consistent. The worst single exit type was probably the RSI. Considering that the channel breakout method is a trend-following method, it's probably not surprising that an oscillator performed poorly as an exit technique. The trailing stop probably returned the most variable results. The best results in the Yen and the worst results in crude oil were both achieved with the trailing stop. This may just mean that the size of the floor and/or the lock-in percentage for the trailing stop are market dependent.

One general conclusion from this study is that the type of exit chosen for a trading system can make a big difference in the system's performance, even the difference between winning and losing. How different exits are combined is also clearly important. Although different results would be obtained with different entry rules or different markets, hopefully this study will give you some good ideas for your own trading system development. Just remember to test every assumption and perform good out-of-sample testing and/or real-time tracking before committing real money.

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