Are trading entry strategies or exit strategies more important to profitability?
I have seen this question asked and debated by traders in many places. If you have ever read a trading-related message board, you know that such simple questions can at times spill into heated arguments, where each side is convinced that they are 100% correct and the other side is 100% wrong.
My perspective is that such debates are pointless. In order to trade profitably, traders need to have a rule-set or strategy that captures whatever market event or phenomenon that they think will lead to profits. Trading is less about “right” or “wrong” answers, and more about “what is” and “what works” – and “what works” just about always depends upon the context.
In this article we are going to take a simple stock index swing-trading entry strategy and examine how the results change with three different exit strategies: A time based exit, a “trailing stop” type exit, and a “first profitable open” exit. All exit strategies also use an identical “worst case” stop loss exit.
We will then alter the parameter on the entry strategy (switching the concept from buying weakness to buying strength) and retest all three exit techniques. By the way, the entry technique we are using is simple combination of what I call trading factors. The most important factor is where the prior close occurred within the four day trading range. If you are unfamiliar with this concept, this article applies the idea to just one day’s worth of data, and this article incorporates the idea using a three day trading range.
Let’s start by evaluating the strategy using a “first profitable open” exit strategy. All this means is that you either exit the trade the first open that is above your entry price (day session hours), or you exit at your stop loss level. Here are the results:
This exit strategy creates a high winning percentage, however the average loss is almost 3X the average gain. Many traders would shy away from a strategy with such a lopsided Average gain/average loss figure, however the max consecutive wins (22) vs. losses (2) shows that a high winning percentage can create significant uptrends in equity via having streaks of winning trades.
Next, let’s examine strategy A with the “exit after four days” strategy. Here are the results:
We see that total profits are up, winning percentage is down, and the average gain is now greater than the average loss. If we control for the average holding period length (This version of the strategy holds for four days, the first held for an average of 2.5 days) this strategy generates a higher average profit per day held ($134 vs. $108).
Lastly, let’s examine strategy A with a trailing stop technique: The logic of this exit is, “Exit the first time price dips 10 points below the opening (day session) price.”
Here are the results:
We see that the winning percentage has dropped down to near 50%, but the average gain is now almost two times the size of the average loss. Of the strategies we have evaluated so far, this strategy has the lowest average daily return of $81.90 per contract.
What the above results suggest is that with one reasonably decent entry signal, any numbers of exit techniques seem to yield decent results. What I did not show in this article is that I evaluated the exit techniques over a broad range of parameters and found most of the results to be fairly stable.
One thing I always like to do with strategies is to present the results with a money management approach that allows for compounding. I think this is useful because it re-enforces what I think is the most important concept in trading, and perhaps in all of finance: It is not so much about having the absolute best, or perfect strategy, it is about compounding returns (“cash on cash”) over time. The following graph is the equity curve of Strategy A with the “exit after four days” exit. The money management strategy is to trade 1 stock index (ES) futures contract for every $25,000 in account equity.
Finally, let’s evaluate these same exit techniques, but this time with an inverted version of our entry signal. Rather than buying near a short term low (relative to the recent trading range) the system will buy at a short term high. Let’s call this swing system B. How do these exit signals perform with this new “momentum chasing” system?
Here are the results:
What did I do to “fowl up” the systems so badly? I simply switched one parameter. Rather than buying in the bottom 20% of the recent trading range, I bought in the top 80% of the trading range. With this new “buy high” approach, none of the three exit signals generated a profit.
This mini study accurately depicts something that I have generally found to be true in short-term and swing trading: A good entry signal can work with a wide range of exit strategies. In fact, the particular exit strategy used can have more to do with the personal preference of the trader, as the average or expected profit can be fairly stable over a number of different rule-sets.
On the other hand, buying at the wrong time makes it very difficult (and most likely impossible) to be profitable with any type of exit approach. This is why I am always skeptical when a trader tells me something like “my entry method is great, but to be profitable (in other words, to stop losing money) I first need to master the exit strategy”.
Chances are if it is that difficult to find the “right” exit approach, the entry is no better than random or even has a negative expected value. But, a word of caution: If you ever find a trader saying something like this, don’t expect him to be open to suggestion. Hard-headedness seems to be one of the greatest things that struggling traders have in common. I sometimes wonder if for some market participants, the trading struggle itself (Captain Ahab style?) is more valuable than making money.
Would you like to know the exact parameters that were used in this study? Sign up for my email list here. I will be sending a supplemental report for this article soon.