Trading Process - Step 11

The Trading Process - Know Your Exit Point - Step 11

One of the most important items in trading is knowing when to quit.  No, I am not talking about any particular trade, and where you should place your stop loss level.  I am talking about when to quit trading a system, strategy or method.

If you want to save your trading capital, it is CRUCIAL that you know when you will stop trading a particular method.

I wrote about this in an article (shown below) for SFO Magazine (which is now defunct, since it was published by PFGBest).

The most important thing I found, which most people do not do, is you need to write it down BEFORE you start trading.

It might be: "I, Kevin Davey, will stop trading XYZ strategy when I encounter a 35% maximum drawdown."

Share this pronouncement with a trading colleague, or your spouse.  This will make you more likely to follow it.

Simply put: Without an exit point for stopping trading, you are likely doomed!


Next: Stick to Your Plan


**************************************************************

Know When to Quit a Trading System

August  2010
By Kevin J. Davey www.kjtradingsystems.com

Text size: A⁺ a^–

Congratulations! After a great deal of investigation, you have decided to “go live” with a new trading system. At this point, it is usually easy to determine when to start trading it—as soon as possible! The excitement and anticipation of assumed future profits makes this simple.

The real decision, however, should not be when to start trading the system, but instead when to stop trading it. Unfortunately, most traders never think of this until it is too late.

Why is it important to have a quitting point for a system prior to even starting to trade it?

Before answering that, just to be clear, I am not talking about exits or stop points for any particular trade. That is embedded in the trading system itself. I am talking about ceasing trading on the system itself. And as critical as individual trade exit points are, a system quitting point is probably even more important.

Two key points drive home why it is critical to have a stopping point for any system.

First, protection of capital always has to be your primary goal. Dreams of profits are nice, but preparing for the downside is how most traders stay in the game. Because once your capital is gone, you are out. So you need to have a quitting point that does not ruin you. Even the best systems can go bad, and you should be prepared for that.

Second, in the heat of trading, emotions will run high, especially as losses pile up. A good trader knows that making decisions during this stressful time usually backfires.

Most traders tend to quit at the absolute worst time, probably because they finally have reached the breaking point with the system and threw in the towel.

Having a quitting point written down before trading starts removes the emotion and makes the decision much easier.

Once you are convinced of the need to establish a quitting point for any trading system, the question becomes, what criteria should be used for quitting? Some popular methods—and some unorthodox ones—are discussed here.

MAXIMUM DRAWDOWN

Probably the most popular approach is to base the quitting point on the maximum drawdown (The decline of a financial instrument from the peak price to the trough.). This can be established in dollars or in percentage terms. One problem many people have is they establish this amount based on their personal preferences, which is good, but they do not take history of the system into account, which can be bad.

For example, they might decide to quit after a $10,000 maximum drawdown, which is usually perfectly reasonable. But it is not reasonable if the system’s history shows multiple $10,000 drawdowns, as shown in...

Figure 1.

This might seem obvious, but most people never bother to match the system’s expected drawdown to their personal preferences. Neglecting this is just guaranteeing inevitable failure.

CONSECUTIVE LOSERS

A second popular approach is to quit after a certain number of consecutive losers. In this approach, if the system’s history showed six losses in a row, then if six consecutive losses occur in real time, the system is stopped.

The problem with this method is the randomness of wins and losses could easily lead to more than six losses in a row, depending on the system. Just because six was the longest streak in the past, does not mean it will be the longest streak forever.

PERSONAL OBJECTIVES

One hopes as part of your trading plan, you have listed goals and objectives for any system you trade. For example, your goal might be a 50 percent rate of return with a 25 percent maximum drawdown.

When you picked the system, you thought it would meet your goals, so every six months or so, you should compare your goals to your system. If there is a big divergence, perhaps it is time to stop trading the system—even one that is showing profits.

The key here is that you should have another, better system ready to take its place that also meets your goals.

SYSTEM CHANGE

Whether you are trading your own system, a black box system or following signals of another trader, you should always be on the lookout for drastic changes in the system methodology. For example, if the system history is based on trading the E-mini S&P on the open, and all of a sudden it starts trading in late afternoon, run, don’t walk, from this system.

Or if you find yourself rewriting or tweaking your system rules to show better historical performance, your original strategy is no longer valid. The system is now something different, and you need to stop trading it until you reassess the strategy as if it were brand new.

OTHER APPROACHES

Because the decision to stop is ultimately personal, you can use whatever criteria with which you feel comfortable. A certain amount of money lost in a week or month, or a system winning percentage dropping beneath a certain threshold are two examples.

Basically, if it can be measured and it makes sense to you, then it is a valid criteria to use.

Just as there are standard, simple methods on which you can base your quitting decision, there are also complicated ones.

STATISTICAL PROCESS CONTROL

In manufacturing, the quality of most processes is assured by a technique called statistical process control (SPC). An example SPC-run chart is provided in Figure 2.

In a nutshell, SPC uses knowledge of the process to determine what is normal and what is abnormal. If certain criteria are violated, corrective action (changes to the machine or shutting down the machine) is taken.

This method, although complicated, can be highly effective, as it uses actual trade results to make its decision.

TECHNICAL ANALYSIS OF THE EQUITY CURVE

Many people apply technical analysis to the equity curve of...

the system and trade based on this. An example of this is given in Figure


 3, with a moving average of the equity curve. When the equity is above 


the moving average, the system is turned “on,” and it is turned “off” when


 it is below the moving average.

Although this sounds appealing, two troubling aspects emerge.

First, what length of moving average should be used? Picking the “best” one based on history is just like optimizing a system variable—the best in the past rarely works best going forward.

Second, unless there is trade dependency occurring (if the results of the last trade depend on the trade result right before it), there is no mathematical reason why this method should work.

Other popular technical approaches, such as using breakouts or patterns in the equity curve may work, but they are prone to the same issues, such as overoptimizing or hindsight bias, that make the methods tough to use on price data.

EXIT AT A PEAK

Because most people exit a system after a period of bad performance and the majority ultimately lose, what would happen if you stopped trading a system at a new high? The theory here is that a peak will inevitably be followed by a dip, and at the dip trading can resume.

Psychologically, this method is probably a killer for most traders. Why would one stop trading a system that is doing well, only to pick up when it is doing badly? But it might just work, because it is the opposite of what most people who are losing would do.

PUT IT IN WRITING

By now, you realize the importance of having a quitting point for any system you implement. Additionally, you may have a few more ideas for how to implement one.

The key is that your personal quitting point must be written down before you start trading a system. And, of course, you must follow it.

If you do not establish and record it prior to beginning a trading system, then chances are you will make a rash decision to quit based on the heat of the moment. Or worse, when a quitting point is inevitable, you will bury your head in the sand and continue trading until there is nothing left. As a result, deciding when to quit trading may be the most important decision you make.