Why Multiple Exit Strategies Matter
Exiting the market addresses a series of problems. If the worst-case scenario does not occur—if the trader is not stopped out by an initial protective stop—then the primary task of the trading system becomes to let realized profits grow as much as possible while giving back as little as possible. Only exit strategies can accomplish this. It is important to note the plural: most systems require several exit strategies to properly fulfill this task. Therefore, for each system objective, a different exit strategy may be considered. When designing a system, the trader must think about how to control the reward-to-risk ratio and how to employ various profit-taking exits to maximize profits. Beyond the initial stop-loss, exits can be classified into several broad categories: exits that incur a loss but reduce initial risk, exits that maximize profits, exits that prevent giving back too much profit to the market, and psychological exits. These categories overlap to some degree. Each type of exit offers several techniques that a trader can consider. While reading about each, it is useful to think about how it might fit a particular system. Most exit strategies can be surprisingly well-suited to a system’s goals. The key is to understand the purpose of each exit and to test how it interacts with entries, position sizing, and overall risk management. Without a clear exit plan, even a good entry can turn into a losing trade or a profitable trade that gives back all gains.
Exits That Incur Losses but Reduce Initial Risk
Stop-loss orders are designed for worst-case losses and protect capital. Other exit strategies also produce losses, but they aim to ensure that losses are as small as possible. One such method is the time stop. Generally, traders enter the market because they expect price to move favorably soon after entry. Therefore, if a meaningful entry signal occurs, a potentially useful exit is to leave the market after a period of unprofitability. For example, an exit rule might be: “If this position is unprofitable, exit at the close after two days.” This exit will lose money, but it will lose less than if a worst-case stop is hit. Another use of a time stop is when a very good new trading idea appears, but all available funds are already committed. If the trader is fully convinced of the new opportunity, they might identify the worst-performing position in the portfolio and sell it—either the one with the largest loss or the one that has not grown as quickly as expected. Trailing stops are another category. A trailing stop is a stop that is adjusted periodically according to a mathematical algorithm. A random entry system, for instance, might use a trailing stop placed at three times the volatility of the market, adjusted daily at the close only when the movement is favorable to the trade. After the first day, if price moves favorably or if volatility contracts, the trailing stop moves in a favorable direction. It may still be at a loss, but it is moving in the trader’s favor. If the market moves against the position far enough to trigger the stop, the trader still takes a loss, but it is smaller than the initial stop. Such a trailing stop can be based on many factors, including volatility, a moving average, a channel breakout, or various price consolidations, each with many different variables. The most important point about a trailing stop is that the exit rule continually adjusts so that the exit moves in a favorable direction. This movement may be unprofitable, but it reduces potential loss. Whether to use such a stop must be carefully considered through testing. Often, raising a trailing stop reduces initial risk at the cost of giving up profit potential, but it also means taking a smaller loss. System designers should be aware that if a system uses very tight stops, re-entry strategies may be necessary.
