In the previous podcast episode with Larry Tentarelli, we opened up the opportunity to submit questions for Larry and received quite a few pages of questions.
Surprisingly, a large portion of the questions were about exits.
Why are exits so hot?
I actually asked Larry why he thought exits were such a hot topic and he suggested that perhaps exits are an area that people really struggle with.
This got me thinking about exits more and I recalled an interesting point that Murray Ruggiero made back in episode 42.
I think Murray raised a really important concept which most traders may not even consider when they’re looking at exits and specifically how to choose the best type of exit for your strategy, which we’ll get to in just a sec.
How do you choose the right exit?
Larry was kind enough to share his philosophy behind exits but you may have noticed that he didn’t give exact details about them, which I think was intentional because it’s something that traders really need to figure out for themselves.
So then how do you go about choosing the best type of exits for a strategy?
Let’s take a listen to Murray answering a question from a listener about the impacts of exits on strategy performance.
Andrew: We’ve got a question from Daniel, just basically wondering the impact that exits can have on strategy performance. What do you say about that?
Murray: Well, it’s actually an area that most people haven’t looked at.
The whole concept of exits is one of the least researched topics.
And it is a pretty important topic.
Now, here’s what the problem is: exits need to be paired with certain entries.
So you can’t have the book of exits, because if you had the book of exits, you’d also have to discuss, for each exit, what type of entry does that exit pair with best.
I mean, I’ll give you an example.
Let’s suppose the entry method was a countertrend system.
So you did something like the ConnorsRSI system, where you’re buying when the RSI hit the three-day low, or a 7-7 system, it hit the seven-day low, you buy.
Well, if you had a stop below the market, you could see that that stop, even if you developed some smart stop below the market that looked at some support levels or whatever, might not perform well with that countertrend strategy, because it would get stopped out too soon.
On the other hand it might work very well with a trend-following strategy, because you had enough room above the stop level for the trade to work.
So when you look at stops, you have to look at the entry method, how long the entry method is predictive, and gauge the stops.
So you could create the stop book, but the stop book would also have different stops for different types of entries; maybe not a specific entry, but, okay, here’s a bunch of stops that work in trend-following systems; this is a methodology for countertrend systems.
Now, one of the things that people don’t realize about stops is let’s suppose we have a system and we pair it with a stop method.
There are times that getting stopped out of that trade tells you that the market is not functioning in the mode it has to be in for your entries to work.
Let’s go back to the intermarket stuff we talked about.
My intermarket divergence method is a countertrend method.
So if bonds are going down and utility stocks are going up, we’re going to buy.
Well, let’s suppose I have a stop below the market, and I get stopped at.
Because that intermarket divergence might still exist, because as long as bonds are selling off, as long as utility stocks are going up, I still have the divergence, it might want to get me back in the next day, and then I’ll get stopped out again.
Do you see the problem?
So what I do is I actually have in TraderStudio a function called disable after exit.
I’ll take certain stops that I’ve designed that if I get stopped out, my market analysis, my market mode is wrong, and I will turn off my entries when certain stops are hit, and that area of research is pretty exciting.
Now the problem is if you’re coding something like this in TradeStation, it’s very difficult and you’d have to write custom code for every single variation. That’s kind of why I use TraderStudio and built tools that I have in studio, which, of course, I sell, but these tools are disabled after exit. So it’s now one command line of code.
So I put the exit name, the entry name and the condition to turn the entry back on, and now I can gauge— so now when a certain stop gets hit, I know that the market’s not working for my entries and I can turn them off for ten days.
I could require the RSI to go back above fifty to tell me that the market has had at least a mild bounce before I try to make a long trade again.
So that’s the problem.
That’s why no one’s ever done a book of stops, because you have to pair it with different types of entries.
So that stop book would have chapters where you have a generic entry method and then a list of stops and how to use them for those methods.
You couldn’t just say that good exit methods will work.
Good exit methods only have to be paired with an entry method that matches that exit.
Make them match!
So Murray makes a couple of interesting points there but I think one of the main ideas was that exits should match the entry and when you’re looking at the type of exit to use you may want to consider what the entry is doing and what type of an exit can compliment that.
I think for alot of traders its common just to try a bunch of our favorite exits and see what works but Murray suggests a more measured approach which we may want to keep in mind the next time we’re looking at exits.
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23 February 2017