Trading Strategy Design – Using Exits

Usually, most trading strategies start with defining a signal to take a position in the market. To design the signal we use set-up and entry which have been described in earlier articles.

For the exits, in theory, we may use reversing of signal to define the exit. For example, if you use trend-following strategies and you enter a long position according to the set-up and entry tell you, then you me exit the market when the set-up and entry tell you to go short.

However, if you find an indicator or signal that tests well, you can improve on it by using various exit strategies. There are various reasons to use an exit rather than just reverse a position.

The most common is you can take a profit at a predetermined price level or indicator level. This would be a profit objective.

Another reason would be when you are writing a strategy that is based on several indicators (perhaps two set-ups and an entry), all indicators must be in gear before a position is taken. When one or two of the indicators turns against the position, the strategy exits the market, waiting for the three indicators to agree again.

One of the most common errors in strategy design is when traders use either the set-up or the entry as an exit. The use of an exit is less important if you focus on the concept of set-up and entry because the set-up and entry technique is very effective by itself. So, using either set-ups or entries as exits is not the recommended thing to do.

Exits must based on market activity. Exits must not be designed to save you money or protect your capital. That is what we have to stops for. Exits should be used to increase your profits.

Exits may be more appropriate for short-term trading strategies, such as volatility expansion strategies or support and resistance strategies, than the long-term trading strategies such as trend-following strategies. Since the short-term trades can take advantage of short-term market conditions.

For example, in a volatility expansion strategy, we wait for the next increase in volatility and then enter the market. We would then devise an exit that would get us out of the market when the volatility increase had run its course. Or, when we had achieved our profit objective.

While in trend-following strategies, we must be sure that if the exit rule gets us out of the market, the entry makes sure that we are back in for the big move for which the strategy is designed. Sometimes using an exit signal prevents a timely entry back into the market, and the strategy misses the next move.

Taro is an experience trader who trades in stocks, futures, forex. He strongly focuses on technical analysis, trading systems and money management.