Lokesh Madan Lokesh Madan is a strategy business consultant for various high frequency trading companies worldwide with more than 12 years of experience in financial technology, research work and business development

Indepth Study On Exit Strategies For Traders By Lokesh Madan

12 min read

Trade Exit strategies are more complex in nature as compared to Trade In Strategies. It involves different types of analysis i.e Technical Based, Fundamental based& Quantitative based. In this article we are not focusing on the timing of trade entries but to the major problem trader’s faces: how to get out of a trade once in Exit Strategies.

WHY TO STUDY: EXIT STRATEGIES

In many ways, a good exit is more critical and difficult to achieve than a good entry.

The big difference is that while waiting for a good opportunity to enter a trade, there is no market risk. If one opportunity to enter is missed, another will always come along-and a good, active trading model should provide many such opportunities.

When a trade is entered, however, exposure to market risk occurs simultaneously.

Failing to exit at an appropriate moment can cost dearly and even lead to the dreaded margin call! We actually know someone who made a quick, small fortune trading, only to lose it all (and then some) because the exit strategy failed to include a good money management stop! To get out of a trade that has gone bad, it is not a good idea to simply wait for the next entry opportunity to come along.

A good exit strategy must, above all, strictly control losses (Stop Losses), but it must not sacrifice too many potentially profitable trades in the process; i.e., it should allow Profitable trades to fully mature.

 
How important is the exit strategy?

If risk can be tightly controlled by quickly bailing from losing trades, and done in such a way that most winning trades am not killed or cut short, it is possible to turn a losing system into a profitable one!

It has been said that if losses are cut short, profits will come. A solid exit strategy can, make a profitable system even more lucrative, while reducing equity volatility and drawdown. Most importantly, during those inevitable bad periods, a good exit strategy that incorporates solid money management and capital preservation techniques can increase the probability that the trader will still be around for the next potentially profitable trade.

FEATURES A GOOD EXIT STRATEGY MUST HAVE.

There are two major goals that a good exit strategy attempts to achieve.

1) The first and most important goal is to strictly control losses. The exit strategy must dictate how and when to get out of a trade that has gone wrong so that a significant erosion of trading capital can be prevented. This goal is often referred to as money management and is frequently implemented using stop-loss orders (money management stops).

2) The second goal of a good exit strategy is to ride a profitable trade to full maturity. The exit strategy should determine not only when to get out with a loss, but also when and where to get out with a profit. It is generally not desirable to exit a trade prematurely, taking only a small profit out of the market. If a trade is going favorably, it should be ridden as long as possible and for as much profit as reasonably possible. This is especially important if the system does not allow multiple re-entries into persistent trends. “The trend is your friend,” and if a strong trend to can be ridden to maturity, the substantial profits that will result can more than compensate for many small losses. The profit-taking exit is often implemented with trailing stops. profit targets, and time- or volatility-triggered market orders. A complete exit strategy makes coordinated use of a variety of exit types to achieve the goals of effective money management and profit taking.

TYPES OF EXIT STRATEGIES

There are a wide variety of exit strategies to choose from when developing an exit strategy. In the standard exit strategy, only three kinds of exits were used in a simple, constant manner.

A fixed money management exit was implemented using a stop order: If the market moved against the trade more than a specified amount. The position would be stopped out with a limited loss. A PNL target exit was implemented using a limit order: As soon as the market moved a specified amount in favor of the trade, the limit would be hit and an exit would occur with a known profit.

The Time-Based exit was such that, regardless of whether the trade was profitable, if it lasted more than a specified number of bars or days, it was closed out with an at-the-market order. There are a number of other exit types not used in the standard exit strategy: trailing exits, critical threshold exits, volatility exits, and signal exits.

A trailing exit, usually implemented with a stop order and, therefore, often called a trailing “top, may be employed when the market is moving in favor of the trade. This stop is moved up, or down, along with the market to lock in some of the paper profits in the event that the market changes direction. If the market turns against the trade, the trailing stop is hit and the trade is closed out with a proportion of the profit intact.

A critical threshold exit terminates the trade when the market approaches or crosses a theoretical barrier (e.g., a trendline, a support or resistance level, a Fibonacci retracement, or a Gann line), beyond which a change in the interpretation of current market action is required. Critical threshold exits may be implemented using stop or limit orders depending on whether the trade is long or short and whether current prices are above or below the barrier level.

If market volatility or risk suddenly increases (e.g., as in the case of a “blow-off top), it may be wise to close out a position on a volatility exit. Finally, a signal exit is simply based on an expected reversal of market direction: If a long position is closed out because a system now gives a signal to go short, or because an indicator suggests a turning point is imminent, a signal exit has been taken.

Many exits based on pattern recognition are signal exits.

Money Management Exits

Every exit strategy must include a money management exit. A money management exit is generally implemented using a stop order. Therefore, it is often referred to as a money management stop. Such a stop closes out a trade at a specified amount of adverse excursion (movement against the trade), or at a specified price below (if long) or above (if short) the price at which the trade was entered. A money management stop generally stays in place for the duration of the trade. Its purpose is to control the maximum risk considered tolerable. Of course, the potential risk may be greater than what was expected.

The market could go limit up (or down) or have a large overnight gap. Trading without a money management stop is like flying in a rickety old plane without a parachute, The issue is not whether a money management stop should be used. Rather, it is determining the optimal placement of the stop. There are many ways to decide where to place money management stops, The simplest placement occurs by assessing the maximum amount of money that can be risked on a given trade. For example, if a trade on the NIFTY 50 is entered and the trader is not be willing to risk more than one Lakhs, a money management stop that uses a one lakhs stop-loss order would be specified. If the market moves against the trade more than one lakhs, the stop gets hit and the position is closed out. Another way to set the money management stop is on the basis of volatility. In volatile markets and periods, it may be a good idea to give trades more room to breathe, i.e., to avoid having the stop so close to the market that potentially profitable trades get stopped out with losses.

A good way to set a money management stop is on the basis, of a price barrier, such as a trendline or support/resistance level. In such cases, the stop also serves as a critical threshold exit. For example, if there are a number of trend and support lines around 7800.00 on the Nifty 50, and a long position at 7900 has just been entered, it might be worth considering the placement of a stop a little below 7900 i.e at 7880. Setting a protective stop at 7880 is logical since a break through support suggests that the trend has changed and that it is no longer smart to be long the Nifty 50. In this example, risk is substantially less than the one lakhs risked when using the money management stop that was based on a Rupees amount. A tighter stop can often be set using a barrier or critical price model than would be the case using a simple Rupees amount model.

As hinted above, setting a money management stop involves a compromise. It is good to have a very tight stop, since losing trades then involve only tiny, relatively painless losses. However, as the stop is tightened (i.e., moved closer to the entry or current price), the likelihood of it getting triggered increases, even if the market eventually moves in favor of the trade. For example, if a 5000 Rs/- stop loss is set, almost all trades on the Nifty 50, regardless of entry method, will be stopped out with small losses. As a stop gets tighter, the percentage of winning trades will decrease. The stop eventually ends up sacrificing most of what would have been profitable trades. On the other hand, if the stop is too loose, although the winning trades are retained, the adverse excursion on those winners, and the losses on the losing trades, will quickly become intolerable. The secret is to find a stop that effectively controls losses with out sacrificing too many of the trades that provide profits.

Trailing Exits

A trailing exit is usually implemented with a so-called trailing stop. The purpose behind this kind of exit is to lock in some of the profits, or to provide protection with a stop that is tighter than the original money management stop, once the market begins to move in the trade’s favor. If a long position in the NIFTY 50 is taken and a paper profit ensues, would it not be desirable to preserve some of that profit in case the market reverses? This is when a trailing stop comes in useful. If a one lakhs money management stop is in place and the market moves more than one lakhs against the trade, the position is closed with a one lakhs loss. However, if the market moves 75K in the trade’s favor, it might be wise to move the old money management stop closer to the market’s current price, perhaps to 30K above the current market price. Now, if the market reverses and the stop gets hit, the trade will be closed out with a 30K profit, rather than a one lakhs loss! As the market moves further in favor of the trade, the trailing stop can be moved up (or down, if in a short position), which is why it is called a trailing stop, i.e., it is racheted up (or down), trailing the market-locking in more of the increasing paper profit.

Once it is in place, a good trailing stop can serve both as an adaptive money management exit and as a profit-taking exit, all in one! As an overall exit strategy, it is not bad by any means. Trailing stops and money management stops work hand in hand. Good traders often use both, starting with a money management stop, and then moving that stop along with the market once profits develop, converting it to a trailing stop. Do not be concerned about driving the broker crazy by frequently moving stops around to make them trail the market. If trading is frequent enough to keep commissions coming in, the broker should not care very much about a few adjustments to stop orders. In fact, a smart broker will be pleased, realizing that his or her client is much more likely to survive as an active, commission-producing trader, if money management and trailing stop exits are used effectively.

How is the placement of a trailing stop determined? Many of the same principles discussed with regard to money management exits and stops also apply to trailing exits and stops. The stop can be set to trail, by a fixed rupees amount, the highest (or lowest, if short) market price achieved during the trade. The stop can be based on a volatility-scaled deviation. A moving threshold or barrier, such as a trend or Gann line, can be used if there is one present in a region close enough to the current market action. Fixed barriers, like support/resistance levels, can also be used: The stop would be jumped from barrier to harrier as the market moves in the trade’s favor, always keeping the stop comfortably trailing the market action.

Profit Target Exits

A profit target exit is usually implemented with a limit order placed to close out a position when the market has moved a specified amount in favor of the trade. A limit order that implements a profit target exit can either be fixed, like a money management stop, or be moved around as a trade progresses, as with a trailing stop. A fixed profit target can be based on either volatility or a simple rupees amount. For example, if a profit target of 30K is set on a long trade on the NIFTY 50, a sell-at-limit order has been placed: If the market moves 30K in the trade’s favor, the position is immediately closed. In this way, a quick profit may be had.

There are advantages and disadvantages to using a profit target exit. One advantage is that, with profit target exits, a high percentage of winning trades can be achieved while slippage is eliminated, or even made to work in the trader’s favor. The main drawback of a profit target exit is that it can cause the trader to prematurely exit from large, sustained moves, with only small profits, especially if the entry methods do not provide for multiple reentries into ongoing trends. All things being equal, the closer the profit target is to the entry price, the greater the chances are of it getting hit and, consequently, the higher the percentage of winning trades. However, the closer the profit target, the smaller the per-trade profit.

For instance, if a 3K profit target is set on a trade in the NIFTY 50 and the money management stop is kept far out (e.g., at 5 lakhs), more than 95% of the trades will be winners! Under such circumstances, however, the wins will yield small profits that Will certainly be wiped out, along with a chunk of principal, by the rare 5 lakhs loss, as well as by the commissions. On the other hand, if the profit target is very wide, it will only occasionally be triggered, but when it does get hit, the profits will be substantial. As with exits that employ stops, there is a compromise to be made: The profit target must be placed close enough so that there can be benefit from an increased percentage of winning trades and a reduction in slippage, but it should not be so close that the per-trade profit becomes unreasonably small. An exit strategy does not necessarily need to include a profit target exit. Some of the other strategies, like a trailing stop, can also serve to terminate trades profitably.

They have the added benefit that if a significant trend develops, it can be ridden to maturity for a very substantial return on investment. Under the same conditions, but using a profit target exit, the trade would probably be closed out a long time before the trend matures and, consequently, without capturing the bulk of the profit inherent in the move.

Personally, we prefer systems that have a high percentage of winning trades.

Profit targets can increase the percentage of wins. If a model that is able to reenter active trends is used, profit target exits may be effective. The advantages and disadvantages really depend on the nature of the system being trading, as well as on personal factors.

One kind of profit target we have experimented with, designed to close out dead, languishing trades that fail to trigger other types of exits, might be called a shrinking target. A profit target that is very far away from the market is set.

Initially, it is unlikely to be triggered, but it is constantly moved closer and closer to where the market is at any point in the trade. As the trade matures, despite the fact that it is not going anywhere, it may be possible to exit with a small profit when the profit target comes into a region where the market has enough volatility to hit it, resulting in an exit at a good price and without slippage.

Interest Based Exits

I saw some Portfolio management companies work strictly on system they design they generally use two Exit policy.. First for Stop Loss & second for profit taking.. Most commonly 10% portfolio drawdown in any sector is Stop loss & profit taking depends on what interest rate they want to book what they calculated means depend upon the risk they take & analysis they make it can be 25% to 100% on any sector.

Time-Based Exits

Time-based exits involve getting out of the market on a market order after having held a trade for a fixed period of time. The assumption is that if the market has not, in the specified period of time, moved sufficiently to trigger a profit target or some other kind of exit, then the trade is probably dead and just tying up margin. Since the reason for having entered the trade in the first place may no longer be relevant, the trade should be closed out and the next opportunity pursued.

Volatility Exits

A volatility exit depends on recognizing that the level of risk is increasing due to rapidly rising market volatility, actual or potential. Under such circumstances, it is prudent to close out positions and, in so doing, limit exposure. For instance, when volatility suddenly expands on high volume after a sustained trend, a “blow-off top might be developing. Why not sell off long positions into the buying frenzy?

Not only may a sudden retracement be avoided, but the fills are likely to be very good, with slippage working with, rather than against, the trader! Another volatility exit point could be a date that suggests a high degree of risk, e.g., anniversaries of major market crashes: If long positions are exited and the market trends up instead, it is still possible to jump back in. However, if a deep downturn does occur, the long position can be reentered at a much better price!

What else constitutes a point of increased risk? If an indicator suggests that a trend is about to reverse, it may be wise to exit and avoid the potential reversal.

If a breakout system causes a long entry into the NIFTY 50 to occur several days before the full moon, but lunar studies have shown that the market often drops when the moon is full and the trade is still being held, then it might be a good idea to close the position, thus avoiding potential volatility. Also remember, positions need not be exited all at once. Just a proportion of a multi contract position can be closed out, a strategy that is likely to help smooth out a trader’s equity curve.

Barrier Exits

 A barrier exit is taken when the market touches or penetrates some barrier, such as a point of support or resistance, a trendline, or a Fibonacci retracement level. Barrier exits are the best exits: They represent theoretical barriers beyond which interpretation of market action must be revised, and they often allow very close stops to be set, thereby dramatically reducing losses on trades that go wrong. The trick is to find a good barrier in approximately the right place. For example, a money management stop can serve as a barrier exit when it is placed at a strong support or resistance level, if such a level exists close enough to the entry price to keep potential loss within an acceptable level. The trailing exit also can be a barrier exit if it is based on a trend line.

Signal Exits

Signal exits occur when a system gives a signal (or indication) that is contrary to a currently held position and the position is closed for that reason. The system generating the signal need not be the same one that produced the signal that initiated the trade. In fact, the system does not have to be as reliable as the one used for trade entry! Entries should be conservative. Only the best opportunities should be selected, even if that means missing many potential entry points, Exits, on the other hand, can be liberal. It is important to avoid missing any reversal, even at the expense of a higher rate of false alarms. A missed entry is just one missed opportunity out of many. A missed exit, however, could easily lead to a downsized account! Exits based on pattern recognition, moving average crossovers, and divergences are signal exits.

 

For more Details

http://algotradingindia.blogspot.in/2014/08/indepth-study-on-exits-strategies-for.html

 

Lokesh Madan

http://algotradingindia.blogspot.in/

Lokesh Madan Lokesh Madan is a strategy business consultant for various high frequency trading companies worldwide with more than 12 years of experience in financial technology, research work and business development

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2 Replies to “Indepth Study On Exit Strategies For Traders By Lokesh…”

  1. i am one of the director out of 4 for a private limited company in india. unfortuante, our business is under loss. myself and another direcor are running the operations & marketing of the business while the other 2 directors are the investors.

    What is the best Exit plan you can suggest us right now.

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