No entry is foolproof, and many successful traders are wrong over half the time. Good exits aid capital preservation when you are wrong, and maximize profits when you are right.
The nature of your trading strategy should always be considered when thinking of exits; there are no universally successful exits. Small profit targets tend to work well in short-term countertrend strategies. For long-term trend trading, where capturing the occasional long trend is critical, wide trailing stops tend to perform better.
Continuing from our trend following CCI entry, we will now develop suitable exits for the hourly GBPJPY. A maximum of two exits will be applied, each with one optimizable parameter.
The net profit/max drawdown ratio used previously in entry selection will continue to be the main performance metric. The following metrics will be taken into consideration as well:
- Number of trades – Needed for statistical significance
- Expectancy – Can transaction costs be covered?
- Maximum drawdown – Needed for capital allocation
Exit Selection Testing
Let’s get straight to it.
Most traders usually exit the market using one or more of the following exits:
- Catastrophic stop losses
- Trailing stops
- Time stops
- Profit targets
In a reversal strategy, the exit of a long trade is also the entry point of a short trade. Reversal strategies seem to be viewed unfavourably in general, perhaps due to their simplicity.
I find that they perform surprisingly well for trend following strategies, which usually don’t use much trade management. It makes sense to simply ride the trend until it reverses.
Since we backtested reversal trend strategies during entry selection, the reversal exit will be used as the initial baseline.
The remaining exits above will now be tested. If they improve the baseline performance, they will be added to the strategy.
2. Catastrophic Stop Losses
In general, I only add a trading rule if it benefits the trading solution. However, I do have a strong preference for using a catastrophic stop loss in my strategies.
This stop loss takes you out of the market when your open loss hits your maximum allowable amount, or when you determine that the premise behind the entry has been invalidated. An optimally placed stop caps the losses on the big losers, while still giving your trades sufficient breathing space.
Stop losses are primarily for risk control. Net profit and expectancy usually decrease marginally, but many traders feel that the peace of mind of having a stop more than compensates for this.
Even with a stop loss in place, you may end up losing more than your predetermined trade risk. During times of exceptional volatility (for example the 2015 EURCHF crash), prices may gap through your stop, causing significant slippage.
Some brokers offer ‘guaranteed stops’, at a premium of course. You can consider those if marets are going wild. Or better yet, stay out of the markets completely.
So what options do we have for implementing a stop loss?
There are two popular options: Pip-based or volatility-based stops. Markets are constantly evolving, and adaptive strategy elements like volatility-based stops seem like a great idea.
Average true range (ATR) and standard deviation are two common technical indicators that gauge volatility. A multiple of these indicators is usually used to compute the stop distance. For example, with an ATR stop, your stop price could be 3*ATR below your entry price for a long trade.
Both pip and ATR-based stops will be tested. Pip stops will be optimized from 10-200 pips, in steps of 2, while the ATR stops will have their multiple optimized from 0.5-5, in steps of 0.05.
A 180-pip stop loss is in the middle of the high plateau (pink box) and seems to be the best option. Let’s see whether the performance metrics have been improved over the baseline.
Surprisingly, the max drawdown was not curtailed, but profits have increased. A 180-pip stop loss will be added to the reversal strategy, and will form the new baseline. Note that the reversal exits are still active, because they are required to exit profitable trades.
3. Trailing Stops
With the success of the catastrophic stop, can trailing stops can further improve the trading solution?
A trailing stop moves in tandem with the market when the trades goes in your favour, allowing you to limit your losses without limiting your maximum possible gain. Trailing stops tend to perform best on longer-term trend strategies. They can be activated immediately after the trade goes into profit, or only after a certain profit level has been achieved.
Similar to the stop losses tested above, pip-based and ATR-based trailing stops will be tested. The 180-pip stop loss will be kept in place, and the trailing stops will be activated once the trade is profitable.
The trailing stops did not improve this strategy. There were even some parameters where the strategy was an overall loser. Perhaps too many trades were choked off by the advancing stops.
This does not mean that trailing stops don’t work for trend following though. They are actually my favourite trade management feature for trend strategies. There are other simple yet effective trailing stops that you can try for your strategy.
4. Profit Targets
Analogous to stop losses, profit targets close your position once your open profit reaches a target level.
In general, they do not work well on trend following strategies, because they violate the rule of letting your profits run. However, they take you out of the market at the equity high of the trade, minimizing open trade drawdown.
Once again, both pip-based and ATR-based profit targets will be tested. To accommodate the possibility of capturing large trends, the range of pips tested will be increased to 20-500, while the ATR multiples will be increased to 1.0-10.
Addition of profit targets failed to improve the baseline. I find that they usually only work well in countertrend strategies.
5. Time Stops
With a time stop, you exit your position after a certain amount of time has elapsed, or when a certain time of day/week is reached. Capping your time in the market has a few advantages:
- Reduces systematic risk caused by economic and geopolitical factors
- Allows more efficient use of capital
- A strategy with less time in the market is usually less correlated with other strategies in your portfolio
Time stops are simple, yet can be surprisingly effective. In fact, champion trader Kevin Davey mentioned that time stops are one of his favourite exits.
Trend strategies usually stay in the market for longer periods; having an end-of-day or end-of-week time stop does not seem to make sense.
Let’s test a bar-based time stop instead. We will exit the position after a certain number of bars has elapsed. The strategy will be optimized with a time stop, ranging from 2-250 bars, in steps of 2.
The 225-250 bar region has the highest NP/DD values, and is reasonably stable. A 240-bar time stop, corresponding to two trading weeks for the hourly GBPJPY, will be chosen.
It is possible that time stops over 250 bars will lead to greater strategy improvements, but I prefer to avoid such long holding periods. The corresponding metrics are below:
The maximum drawdown has decreased by about 9% while net profits have remained unchanged, leading to an improvement in the NP/DD ratio.
The number of trades actually increased, showing that you can expect to hold trades for longer than two weeks with a reversal strategy. This substantial time in the market is one reason a pure reversal strategy is risky.
A variety of trading exits have been tested on our GBPJPY trend-following strategy. The addition of a 180-pip catastrophic stop loss and a 240-bar time stop have increased the strategy’s net profit/max drawdown ratio from 5.26 to 6.18.
In this instance, the trailing stop performed worse than the catastrophic stop, although better performance may be achieved if the trailing stop is only activated after a certain profit threshold.
Profit targets failed to improve the trading solution, as is usually the case for trend strategies.
Can we still improve the strategy?
In the final part of the MT4 development section, let’s attempt to improve our win rate by implementing entry filters.