Exit Strategies for Traders The Good, the Bad, and the Ugly A presentation by Chuck LeBeau Director of Analytics, y , www.SmartStops.net p Legends of Trading Forum Chicago 2010 What we intend to cover Problems with most trailing exits The good, the bad, and the ugly Proposed solutions Chandelier exits Modified Parabolic Targeted exits for short-term traders Other methods to exit on strength Challenges of using trailing stops 1. Always know when to sell 2 2. Li i risk Limit i k & maximize i i profits fi 3. Avoid “whipsaws” 4. Have a reentry 5. Ease of use Most popular methods of setting trailing stops are seriously flawed We will now look at some common methods of setting stops and discuss their strengths and weaknesses Percentage trailing stops The Good: Ease of calculations Objective j (no ( chart analysis) y ) The Bad: Stops get closer or farther away based on price levels No adjustment for trend strength or direction No research on what percentages work best (8%, 10%, 25% or some other percentage ???) The Ugly: Subtract percentage from where? From entry? From recent high? After price breaks by selected percentage – where is next stop? Moving Average trailing stops The Good: Ease of calculations Objective j (no ( chart analysis) y ) The Bad: Which moving average should you use? No adjustments for direction of trends No adjustment for changes in volatility The Ugly: Too slowslow rapidly rising prices quickly get too far away from MA After MA is broken – where is next stop? They will drive you crazy in sideways markets!! Exit at “Support levels” The Good: No calculations The Bad: Highly subjective – expert chart analysis required Support levels do not move up as prices accelerate No adjustment for changes in direction or volatility The Ugly: Too slow- Rapidly rising prices quickly get too far away Not suited to downtrends – where is next stop? Exit at Trend Lines The Good: No calculations Th B The Bad: d Highly subjective – expert chart analysis required No adjustment for changes in direction or volatility F Frequent t whipsaws hi in i sideways id market k t The Ugly: Too slowT l R idl rising Rapidly i i prices i quickly i kl gett too t far f away Not suited to downtrends – where is next stop? Exit at Parabolic SAR The Good: Accelerate very quickly to keep pace with rising prices Th B The Bad: d Complicated calculations requiring computer and software No adjustment for changes in direction or volatility F Frequent t ““whipsaws” hi ” in i sideways id markets k t The Ugly: Nott suited N it d tto d downtrends t d – where h is i nextt exit? it? Does not let profits run for big gains Exits at SmartStops.net p The Good: Cuts losses short while letting profits run Automatically adjusts to trend direction Automatically adjusts to changes in volatility Completely objective – no charts to read Provides exit prices in advance of use Choice of short-term and long-term time frames Timely email notification when exit prices are hit When necessary, exits move farther away to avoid whipsaws The Bad: Service is only free for 14 days on a trial basis The Ugly: There is no ugly gl – SmartStops are beautiful! Q Quick comparison p to “buy and hold” From the beginning of 1998 thru July 2009, a buy and hold approach using 1,000 shares of the SPY (ETF for the S&P 500) would have lost $6,940. If SmartStops exits were combined with a simple reentry at 20 day highs over the same period the result would have been a profit of highs, $52,970. The SmartStops exits improved results over this ten-year ten year period by a total of $59,910! How the SS strategies work 1. The exits are adjusted according to trend direction: In an uptrend p the exits trail at a distance in order to let profits run. In a downtrend the exits are moved closer to protect more capital. IIn sideways id markets k the h exits i trail il just j outside id the h range off random price swings to avoid “whipsaws”. How the SS strategies work 22. The exits are accurately adjusted to changes in volatility as measured by Average True Range: The “normal” price ranges are mathematically defined in units of ATR. To avoid “whipsaws”, the exits are placed outside the normal price swings. Only an “abnormal” period of weakness will trigger an exit signal. Range True Range “True” True range adjusts for gaps How the SS strategies g work 3. In upward trending markets the “Chandelier Exit” allows the exits to keep p up p with p price acceleration: A stop is placed (3?) Average True Ranges from the highest high since entry of the trade or the highest high over some defined period of time. Because the stop is attached to the high point it moves up at the same rate that the high moves. The length of the chain on the Chandelier is measured in units of ATR and will automatically adjust to changes in volatility. Adjusting the chain on the Chandelier Exit keeps the stops from getting too close or too far away. How the SS strategies g work 4. A highly modified Parabolic indicator allows the stops to gradually accelerate without getting too close: The Parabolic Th P b li is i modified difi d to t make k it a long-only l l indicator i di t andd it never reverses. The acceleration of the Parabolic is slowed so it does not accelerate too fast. Thee Parabolic a abo c iss modified od ed so that a it iss not o aallowed owed too move ove inside s de thee range of normal price activity. How the SS strategies work 5. Combine the exit signals g with a foolproof p and intelligent method of reentering trades after an exit: Try y to find indicators such as MACD and ADX that can signal g when strength has returned to a position you may have previously sold. Our research has shown that following a reentry methodology as simple as the “Donchian 4-week breakout” or the “Turtles 20-day breakout” would prevent missing any major opportunities. SmartStops S S uses two proprietary i reentry methods. h d Wh When the h trendd is i down the reentries are slow to trigger. When the trend is up the reentries will trigger quickly. Advice: Overcome “Whipsaw” Paranoia The only way to completely avoid whipsaws is to not use protective stops. Unfortunately that drastic solution would expose investors to unacceptable levels of risk. In order to mitigate the consequences of a premature exit signal, a plan of reentering needs to be in place. y show that,, in the longg run,, the benefits of usingg Our studies clearly protective trailing stops will far exceed the expense or lost opportunity costs of an occasional whipsaw. Learn to accept the occasional whipsaw as simply a cost of doing business and make sure that you are always prepared to reenter if a strong g upward p trend is resumed. Ad i Learn “Position Sizing” Advice: Use your protective stops to determine your correct “position position size” size . Here are the simple steps: 1. Select a percentage level of risk relative to the size of your portfolio. Example – a portfolio of $100,000 might select a risk level of 1.5% so risk should be limited to $1,500 on each trade. 2. Pick a stock and find your precise worst-case exit based on your exit strategies. Example – buying a $25 stock and the exit stop is at $22. Risk is $3 per share so correct position size is 500 shares. ($1500 risk limit divided by $3 risk to your exit point) Remember, controlling risk is a two step process: use protective exits it and d th then make k sure you control t l your iinitial iti l position iti size. i Advice: for Short-term traders Most of the exits discussed in this presentation work best for long long-term term trend followers who are able to hold positions until weakness is detected. Short-term traders may use trailing stops for protection but should plan to exit on strength in order to maximize short-term profits. Here is one of my favorite exit-on-strength techniques. It is extremely simple and uses Welles Wilder’s RSI indicator. However other overbought/over-sold oscillators would also work. (Stochastics, William’s Percent R, various bands, etc.) We will also be discussing the use of targeted exits. U ATR tto sett profit Use fit ttargets t Units of ATR are perfect for setting profit targets because they contract and expand as volatility changes. In volatile markets ATR profit targets will be bigger. In quiet markets ATR targets will be smaller. Short-term traders might expect maximum profits to be about 2 ATRs using a 3-period ATR calculation. Although it is more difficult and less accurate, targets can also be used by longer-term traders using a longer ATR (20 periods) and a larger ATR multiple (4 or higher). Th k ffor attending Thanks tt di For additional education and many informative articles be sure to visit www.SmartStops.net and www.TraderClub.com. You are welcome to contact me by email at Chuck@SmartStops.net if you have any questions about this presentation or about SmartStops. Good luck and good trading!