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.
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