In the part 3 of this series, we focused on the entry rules for the ConnorsRSI Pullback Strategy. But entries are only half the story. You don’t make (or lose) money until you exit the trade, so having a precise, quantified exit method is crucial to generating predictable returns. Unfortunately, many published strategies either gloss over the exit rules completely, or they rely on vague directives such as “exit when you reach your profit target”. Since they don’t specify how to calculate a reasonable profit target, this is basically equivalent to saying “exit when you feel like you’ve made enough money”, which is not very helpful at all.
Let’s talk conceptually about entries and exits for a moment. Both entry and exit rules can be thought of in terms of how strict they are, i.e. how easy or difficult they are to achieve. You might also say that strictness is a measure of how frequently or infrequently the rule conditions occur. For oscillators such as ConnorsRSI, values that are closer to the extremes (0 and 100) are more strict (less likely to occur) than values that are in the middle of the range.
Stricter entry rules will be satisfied less frequently than more lenient entry rules, and thus a strategy that relies on the stricter rules will typically generate fewer trades than a strategy whose entry rules are more easily satisfied. With a robust strategy, the reward for fewer trades is generally a higher gain per trade, on average. If you buy a slightly oversold stock, it’s most likely to have a moderate rebound. But if you wait for a stock that’s extremely oversold, the chances are much higher that it will have a significant bounce and create a bigger profit.
The strictness of exit rules has little effect on the number of trades generated by the strategy. However, just like the entry rules, stricter exit rules typically result in higher average profits. Why? Because stricter exit rules tend to keep you in your trades for a longer time, giving the stock more time to experience the mean reversion behavior that we’re attempting to exploit with a strategy like the ConnorsRSI Pullback Strategy. Thus, for entries the tradeoff is between more trades and higher gains per trade, while for exits the tradeoff is between shorter trade durations and higher gains per trade.
It turns out that ConnorsRSI is not just a great entry indicator; it’s also a very reliable method for measuring the degree to which we’ve captured the mean-reverting price bounce. Therefore, our exit method is to simply wait for ConnorRSI to reach a predetermined level. We’ve found that a value of 70 is a very effective exit indicator, as it creates a good balance between capturing most of the gain without making the trade duration unduly long.
Thus, we can express Rule 8, our exit rule, as:
- Exit the position when the stock closes with a ConnorsRSI value above 70.
In Part 5 of this Pullback trading series, we’ll look at an example of a complete trade.