By Chuck LeBeau.
The outcome of every trade is dependent on the exit. If we enter in a timely fashion and then exit poorly, the trade is likely to be a loss. If our entry happens to be poor but our exit is good we might still salvage a profit. The exits, not the entries, determine the outcome of our trades. This lesson about exits is easily demonstrated. Take any entry strategy and begin combining it with different exit strategies. You will quickly see that we can change the results dramatically by making only minor adjustments to the exits. In fact it becomes nearly impossible to tell if an entry is any good because the results are so exit dependent. Bad exits can make a good entry look bad and good exits can make a bad entry look good.
When testing the validity of an entry method it is best to begin by simply exiting the trades after a number of bars. If you do anything more creative than this simple exit you will find that you are really testing your exits, not your entries. If you change the exits while attempting to test an entry strategy the results will vary so much depending on the exits selected that you will find that you can not make any valid assumptions about the reliability of the entry. When combined with the right exit the entry strategy looks great. When combined with the wrong exit the same entry looks terrible.
The purpose of an entry is to get the trade started in the right direction. To test the effectiveness of an entry we simply measure what percentage of the time it gets our trade started in the right direction. For example if we have entry “A” that has 60% winning trades after five days it is better than an entry “B” that has only 45% winners after five days.
You will notice that we made no comparison of risk or profitability in picking the best entry. What if entry “A” lost money and entry “B” made money? Is entry “A” still better? The answer is “Yes” because the purpose of an entry is merely to get the trade started in the right direction. After that everything else is dependent on the exits. Entry “B” just happened to make more money because of the particular exit we selected for the test. We can easily adjust our exits and we will find that entry “A” will consistently make more money than entry “B” because it gets the trades started in the right direction more often. To maximize our profit we need to combine the right entry with the right exit.
In our book, Computer Analysis of the Futures Market, we tell an amusing anecdote about a trader who seemed a bit loony because he used a Coke bottle with a broken radio antennae sticking out of it to receive trading advice from other planets. This advice, like most trading advice, was only related to the entries. When the voice from the Coke bottle told him to enter a trade he would come back to my desk and want to put the trade on right away saying something like: “They are buying soy beans on Mars, buy some beans for me”.
The other traders sitting around the board room would overhear these frantic orders and became quite interested in this strange trading advice. Naturally they were quick to make fun of the trader when he was losing but they didn’t have much to say when he was winning. The trader with the Coke bottle eventually learned that to avoid ridicule he had to take his losses quickly and hold on to his winners as long as possible. His trading steadily improved and he wound up being a surprisingly good trader. Obviously, his reliance on trading advice from other planets had nothing to do with his success. His entries were no better or worse than random but he had learned to be very good at his exits.
We should do the same.
Reprinted with permission by Chuck LeBeau at www.traderclub.com