Exit Strategy

While newcomers and the financial media focus on entry prices for stocks, seasoned market participants recognize that the exit is by far the more important of the two. The exit is what allows us to achieve the most important goal of a good trading system: to preserve capital. When we first enter a holding, we put a sell-stop at the exit price, and this bounds our risk. That risk, in dollar terms, is the difference between the entry and initial exit price, multiplied by the number of shares purchased. Because this amount was one we had deemed acceptable to potentially lose on that particular trade, we are free to let go of the monetary aspects of the trade and instead focus on the job at hand: to optimize the trade.

Optimizing the trade means balancing two goals: maximizing profit potential and minimizing risk. The profit potential aspect depends on the market environment, which is out of our hands. What we as traders can control is our risk appetite, which translates ultimately to managing the twin bugbears of greed and fear. In this discussion, I will focus exclusively on uptrends when I talk about trending markets. In a downtrending market, just assume I am talking about SDS, which goes up as the market goes down, or your contra investment vehicle of choice.

In an uptrending market, profit potential is high because prices tend to continue moving up, and the risk of the trend ending is low. Because risk is low, the best strategy is to let the market lead rather than using target prices, which will invariably be either too high (greed) or too low (fear). If you have a system that consistently predicts the peak of uptrends, then you are just too good, and also I don't believe you. In uptrending markets, the trade optimization strategy is simple: use the definition of a uptrend (that is, higher highs and higher lows) to move sell-stops up as the lows get higher and higher. We will recognize that the trend has ended upon seeing a lower low, upon which time we exit the trade. It is a necessity to accept the fact that we are not aiming to get out at the tippy-top. Rather, the aim is to get out at the low that is closest to the top once the trend finally does end and the stock begins to decline. What one considers the top of the trend depends on one's timeframe. A daytrader may view the mid-morning spike as the top. A long-term Elliot Wave trader would disagree, saying that October 11, 2007 is the top.

Let's do an example trading my Aggressive system. Say we enter CWEI at the breakout on May 2nd, 2008 at 64.61, with our initial stop at 60.99 near the May Day low.


On May 6th CWEI formed a higher low and bounced to close at a new high, all in one day. The stock pivoted, meaning it formed a low and then subsequently a higher high. Thus, our stop gets moved up to just under that day's low at 62.49. Following this principle, the stop is moved to 67.35 (the May 8th low) on May 9th when a new high is reached. On May 19th the stop goes to 70.99 (the May 15th low), and to 76.49 on the breakout of May 30th, recognizing the May 22nd low. CWEI retraces a tiny bit, does a one-day outside reversal on June 5th and that means our stop is now at the low of that day, 94.22. Notice how each of the lows jumps out of the chart. They are all notable (but not severe) perturbations in the uptrend. We are not putting a stop at the low of each day, but being judicious based on the look of the chart. June 17th our stop is moved to 103.49. And that is the price at which we exit CWEI on June 26, the day of the first lower low of this run. By the definition of trend, the lower low means the trend is over. The tippy-top of this trend was 121.50, and although our exit price is $18 away, we are proud of ourselves for getting out at the highest pivot low closest to the peak. (There are ways to systematically get closer to the peak, but that would unnecessarily complicate this talk.) Our profit is 10.74R, where R represents the dollar amount we put at risk on this trade. This systematic method of moving stops up, rather than trying to determine a target price, means that profits are able to grow to heights that we couldn't have imagined, buoyed by a strong uptrend. We also do not take on the risk of holding the stock too long, suffering losses in the ensuing decline due to a too-high target price. We let the market lead us, rather than trying to lead the market.

All of this is thrown out the window during trendless markets. Because most of technical analysis is based on prices trending, systems that employ technical concepts start to malfunction when there is not much of a trend. In such an environment, the task of optimizing trades errs to the side of risk minimization. Profit potential is no longer high because price is buffeted by a fierce tug-of-war between buyers and sellers, getting nowhere. In other words, whipsaws are the norm, and any sustained price action is short-lived. People say day trading systems work well in trendless markets. In fact, day trading systems work even better in trending markets. It's really that all long- and medium-term trend-based systems start failing, and the only ones that work at all are very short-term systems such as ones based on day trades. Participation in such a market requires a close relationship with one's gut because in an environment of constant risk, the slightest sign of trouble needs to be recognized as such and factored into the exit decision. Constant monitoring and re-evaluation of market conditions, as well as early exits, is rewarded. Such impatience is punished with mediocre returns in trending markets. In fact, the percentage return is about the same in trending and trendless markets, but a return that seems mediocre in a trending market is spectacular in a trendless market.

One notable difference between trendless and trending markets is that breakouts are more dramatic in urgency and also have a higher chance of failing right away. Nevertheless, the fact remains that they do occur and can be traded for profits. They simply need to be exited more quickly. One strategy I use is to lie in wait for a breakout and then exit partials on the actual breakout. If the breakout occurs below the stock's 50 or 200-day moving average, I often set a target exit for up to 100% of the position near that moving average. This is one time that target prices provide me with a compelling risk/reward since the chance is significant that the moving average will reject the breakout. If the breakout is sustained, perhaps marking the start of a new trend, I still have a portion that can ride it. If the breakout fails, at least I managed to get a piece of it while the getting was good. This has been my strategy for the past months, and it has worked for me—I'm beating the S&P by a healthy margin so far this year.

The most important part of participating in a trendless market is to keep the faith. At some point, the new trend will emerge. A good trader must have the recognition and the courage to participate, because a trending market is payment for enduring the hell of the trendless environment. There is always the option of not participating in a trendless market. While there is money to be made, primarily by playing breakouts, the danger element means a high chance you'll just lose your money. It is definitely not the type of environment in which to get your feet wet if you are starting out. You will have your hat handed to you; and if you do manage a few successes at first, expect that hat to have a head underneath it. Trendless markets are the worst environments in which to get overconfident. They are the worst environments to get started in. And they are the worst environments, period. By the way, I've read that markets are trendless about a third of the time. It doesn't seem like the percentage should be that high, but it's also possible I blocked out the memories of those times.