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
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Know When to Quit a
Trading System
August 2010
By Kevin J. Davey www.kjtradingsystems.com
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.
