Riding A Great Trend? Know When To Get Out
Most traders have heard the adage “The trend is your friend” at some
point in their careers, but they would be wise to think about the second
part of the title of this article before blindly taking trend signals.
Trading with the trend is certainly one of the most important trading
principles to understand and practice–whether that means using a long-term
trend-following system or a shorter-term approach that simply finds swing
entry points within an already existing trend.
Defining trends and trading in their direction is relatively easy.
However, it’s only one part of the story. Getting in the market on the side
of the trend is one thing, but if you don’t know how to get out with a
profit, it doesn’t do you much good.
With the Internet giving traders unprecedented access to market
information and trading advice, it’s sometimes difficult to sift through
all the trading strategies and concepts at your disposal. Numerous advisory services that suggest which stocks or commodities to buy
or sell, but most of them place little emphasis on where to exit trades–a
critical element of successful trading.
We will take a look at the principles of trading with the trend, but
more importantly, we will explain the importance of timing your exits. In
other words, it’s not just trend-following, it’s how you do it that counts.
Trend-following approaches
There are numerous ways to identify trends and trade in their direction.
Two of the better-known basic approaches are the moving average crossover
approach and the channel breakout approach. Both of these approaches identify trends after they have started and take (usually longer-term) positions in their direction.
The moving average crossover method buys when a shorter-term moving
average (say, 10 days) crosses above a longer-term moving average (say, 40
days) and sells when the shorter-term average crosses below the longer-term
average.
The channel breakout system buys when price exceeds the highest
high of the last N days and sells when price drops below the lowest
low of the last N days. For example, a 40-day channel breakout would
go long when price exceeded the 40-day high and go short when price
exceeded the 40-day low.
These approaches are basic; you can
use a number of techniques to improve their performance (avoid false signals, etc.), such as
adding a confirmation rule that would require the market to stay above the
breakout level for a certain number of days before taking a channel
breakout buy signal.
Timing exits
This is where you have to start making some important decisions. The trend-following methods described above are valid as long as you keep the
profit objectives in line with the system’s characteristics. This simply
means the system’s average profit must be significantly higher than the
system’s average loss. A profitable medium- to longer-term trend-following
system could easily have fewer winning than losing trades (perhaps 35 to 45%),
but the average winning trade is much larger than the average losing
trade.
What does this characteristic boil down to in practical terms? If you
take profits too quickly on your positions you will greatly reduce your
chances of success (bringing up another old adage: “Let your profits run”).
So when traders are considering a particular trading strategy, they should
first study the characteristics of the approach’s losing trades and
determine the average loss. If the strategy does not produce average
winning trades larger than the average losing trades (a 2:1 average
winner/average loser ratio, for example), it is almost sure to fail–even
if there are more winning trades than losing trades. Let’s use an example
to illustrate this point.
Market examples
Table 1 shows the results of trading Intel Corp. (INTC) and
Applied Materials (AMAT) stock from January 1, 1996, to March 16, 1999, using
a simple channel breakout system. To enter a trade, we used a 40-day high
to trigger a buy, executing the trade (100 shares) on the next day’s open.
Then, we tested a number of exits to see how they affected this basic
approach. For example, in Table 1, if we exit our long position when Intel closes below the low of the last two days, the net profit would have been $345. The most important
characteristic of this table is the distinct pattern of deteriorating results that accompanies increasingly shorter exits. (“Profit Factor” in these tables refers to the gross profit of the test period divided by gross loss.)
| INTC: Channel breakout | AMAT: Channel breakout | |
| (1/1/99 – 3/16/99) | (1/1/99 – 3/16/99) |
|
|
Table 1. Performance of 40-day
(entry) channel breakout systems with varying exit lengths for Intel (INTC)
and Applied Materials
(AMAT).
The important message from these results is that you must be willing to
hold positions to make large profits on them. If you take profits
too quickly, you are doomed to disappointment. (Oddly enough, this
contradicts yet another bit of market wisdom: “You can never go broke taking a profit.”)
Figure 1. Channel breakout with
20-day low exit (AMAT). Source: Omega Research.
Figures 1 and 2 show the difference in trade frequency between a 20-day
exit and a 5-day exit in Applied Materials (AMAT). The benefits of the longer exit are immediately apparent from these charts. Look especially at the up trend captured on both charts: The five-day exit would have taken you out of the market early (and repeatedly, if you had continued to re-enter long positions), while the 20-day exit took better advantage of the price move.
Table 1. Channel breakout with
five-day low exit (INTC). Source: Omega Research.
Day trading
Another point to consider is that the concepts outlined here do not just apply to trading daily data. Because we also can find the same patterns in intraday and weekly data, day traders (as well as very long-term trend traders) should pay close attention to how they time their trade exits. No matter what time frame you’re operating on, you have to trade in such a way that you get the most out of the available price moves.
These results are interesting in light of the current stock market environment and the day trading community that has emerged. Many of these traders reason that because online trading commissions are so low, they can trade much more frequently. I strongly suspect these traders would be very surprised to learn that keeping your profit objectives in line with your trading style is much more important than trading frequency.
Taking quick profits on trades can be very dangerous if you do not take into account the nature of your trading methods. A prudent approach might be to take only partial profits in the early stages of a trade, keeping part of your position to capture any subsequent price move.
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