Sunday, March 9, 2008

The Case for Multiple Exits, Part1

The next few posts are going to look at the substantial impact exits have on the results of any given trading methodology. For entries, I will be using a breakout entry that will perhaps be discussed in future posts with permission from the designer. For todays purpose, the entries dont really matter and would not dramatically change the nature of the results.

stockbee.blogspot.com/ ) gave me permission to disclose the entry. These tests use his IBD200 technical entry criteria. I will also add that Pradeep introduces another level of stock selection refinement based on some criteria that are difficult to backtest (float, relative linearity, etc) so those have been excluded from these tests. I have no doubt that proper use of his other methods would further elevate returns. I would also highly recomend the member’s only section of his site as an invaluable information source.

8% Trailing Stop

The first example we are going to look at is about as simple as it gets and probably one of the most often used by those that actually use risk management stops. A trailing 8% stop. Thats it. The 8% number comes from William ONeils maximum recommended loss per trade.

At $1000 per trade, this exit resulted in $78,815 dollars of net profit with a reliability percentage of about 40%, which is pretty typical for a trend following system. The average loss was $50.65 (5%) and the average win was $97.41 (9.7%). The average trade was $8.38 which means that we can expect to make an average of $8.38 per trade over the long run. If we take our AvgTrade/AvgLoss, we can calculate what our expectancy is per dollar risk. $8.38/$50.65 = .165, or for every dollar we put at risk, we have an expectancy of 16.5 cents. Risking 1% of our equity per trade, it would take approximately 600 trades to double our money, not including compounding.

8% Protective Stop+20% Profit Target

For the next example, we will use two separate stops, an 8% protective stop that is fixed at 8% below the entry price and a 20% profit target. We allow the price to hit one or the other before exiting. These are both figures taken from William ONeils publications although he discusses several exceptions to the 20% profit target, which as we will find out later, are very important.

In this example, with the same exact entry criteria at $1000 per trade resulted in $185,919 dollars of net profit with a reliability percentage of about 38%. Our average loss increased to $82.52 (8.2%), but our average win is now $196.99 (19.7%). Our average trade is $24.21 which means that we now expect to make an average of $24.21 for every trade we make. AvgTrade/AvgLoss=$24.21/$82.52 = .293 — for every dollar we place at risk, we now have an expectancy of 29 cents. Risking 1% of our equity per trade, it would take approximately 340 trades to double our money, not including compounding.

8% Protective Stop+25% Trailing Profit Stop

Most people have heard the expression to cut your losers short and let your winners run.

In our last example, we will also use two stops to achieve this. We will begin with an 8% protective stop but instead of a 20% profit target, we will use a 25% trailing profit stop. This stop will follow the price up but will only become active when it raises above the initial 8% protective stop. This will give our winners PLENTY of room to grow without increasing our intitial risk. The point in which the trailing stop becomes active is when our stock price reaches a 17% increase over the entry price (25-8=17).

Well look at that. In this example, with the same exact entry criteria, $1000 per trade resulted in $438,165 dollars of net profit with a reliability percentage of only about 30%. Our average loss stayed about the same at $80.05 (8%), but our average win is now $503.96 (50.4%). Our average trade jumped to $92.93 which means that we now expect to make an average of $92.93 for every trade we make. AvgTrade/AvgLoss=$92.93/$80.05 = 1.16 — for every dollar we place at risk, we now have an expectancy $1.16. Almost 4x the amount of the previous example and 10x the reward to risk ratio of using an 8% trailing stop alone. Risking 1% of our equity per trade, it would only take about 86 trades to double our money, not including compounding.

I want to remind everyone to read the post on backtesting methodology to understand exactly what we are seeing here. These arent necessarily representative of the results you will experience but I can tell you that using these different stops on almost any basket of stocks with almost any entry criteria will yield the same relationships to one another. Stops are huge and the possibilities for using them are endless. Using each of these will create completely different psychological pressures and the drawdowns one might experience with such a large trailing stop might be too much for some to handle. It is important to find a methodology that works for you and your risk profile but not paying them proper attention is clearly a huge mistake.