There is little question among seasoned speculators that exits are more important than entries. All of us have looked back on our trading history, or someone else’s experience, and rued the day when an exit transaction was made too early.
Land sales that yield a 50% rate-of-return in a short-term hot market often turn into 500% returns for the more patient investor. Often, we have held stocks like Microsoft only to sell out when it doubled, thinking we were geniuses. And, of course, who hasn’t sold out at a loss before the position began to move into profits because they needed the money for something else more important at the time?
This is a core dilemma for the trader. Solving it, or at least resolving it in an effective way, is at the heart of trading success.
DIG DEEP
When we started out in trading, we were hounded with axioms that often become established parts of our trading paradigm. Sayings such as “cut your losses short” became unwavering principles that led us to riches or rags. We set out to establish a plan that included such rules. We often assessed the finished plan without questioning these fundamental tenets of the trading discipline.
Of course, the key to any simplified slogan is in the details. The problem in implementing the rule of cutting your losses short has to do mostly with the matters of perspective and technique. We can literally call into question three of the four words used in this short advisory to make that argument. Take the word “cut.”
To the inexperienced, this means get out. Close the position, take your bumps and bruises and live to trade another day. It is often the best advice to take this literally, but there are alternatives; some of these can turn the loss into a profit.
For example, if you use a platform that allows pure hedging, you can place a trade in the opposite direction of the one harboring the loss. When you do this in the same market and in the same quantity as the losing position, you stop the bleeding. This maneuver gives you time to think and reassess the situation without going further into the red. If you close them out simultaneously, you have accomplished virtually the same result as just getting out. If you choose to go one way or the other after you feel more confident about the direction of the market, you can do so by eliminating one of the legs.
Admittedly, a pure hedge accomplishes no more than simply liquidating the position and re-establishing it when it appears profitable again; however, maintaining a position in the market, even if it is rendered flat, provides a different perspective and encourages tighter focus as the trade develops. This often leads to better re-entries.
Another effective loss-cutting technique involves a different kind of hedge and an appreciation of market correlation. This component of professional trading is indispensable in any market, particularly forex.
MOVING TOGETHER
All of us get caught on the wrong side of extended trends from time to time. Without deep pockets, it is impossible to stay in such moves until they turn in your favor. You can make your pockets deeper without adding more money to them.
One maneuver is to snipe profits from an adversely correlated market that is moving in the opposite direction of your losing position. As you continue to incur losses from your wrong-way market, you ameliorate them with profits from short-term trades in the other direction.
An easier technique to implement is using a lead strategy of counter-trend scale trading and complementing that with a supporting trend-following strategy in the same market. Because the two models employ different entry and exit plans, the trades made in these two systems do not offset each other. Rather, one usually makes money when the other encounters a drawdown (see “Two trends,” below). This system diversification deepens our pockets and allows us to sustain dips without bailing out with losses. It even gives us the opportunity to turn those losses into profits with the added staying power.
DOWNSIDE ANALYSIS
Next, we can further examine the term “losses.” A paper loss is no more a real loss than a paper profit is a real profit. Neither counts until you take it; either can disappear. To put this in perspective, you should become familiar with the maximum adverse excursion (MAE) concept.
Like many statistical calculations that empower our system analysis, MAE has been adapted into a number of uses. Simply put, it is the percentage distance a position moves against you before becoming profitable. This only applies to ultimately winning trades. If this adverse movement never becomes positive, there is no MAE.
In a sense, it is a measure of volatility, but a more contaminated one than average true range, for example, or the various envelopes that we use to track price instability. Its impurity lies in that it is measured against a strategy rather than price itself. Your strategy may be to buy high and sell higher. MAE as measured against that plan would likely be greater than the maximum adverse excursion usually experienced against a strategy that tries to pick tops and bottoms, for example.
Nevertheless, it pays to know what the behavior in this regard has been throughout the history of your entries. Blessed be the trader that enters the market at the absolute turning point. It rarely happens, so it helps to know the padding you have above or below your position before you should just give up and get out.
Aside from the comfort tracking the MAE gives the trader, it provides another factor to consider when setting stops (see “Know your losses,” below). If you know from this analysis that several profitable trades go against you by as much as 1%, for example, before turning in your favor, it does not make sense to place your stops at 0.5% from the entry point. Stops that are too tight lead to exits that are too early, and this can be the bane of the inexperienced trader.
As usual, there is a caveat. The application of this rather simple calculation can become complex when incorporating it into your trading plan. The MAE statistic has its own outliers, and they can be problematic if you do not take them into proper account. While you may have a few winners that have gone against you by as much as 3%, for example, the typical analysis finds them bunched near a lesser number. It then makes sense to disregard the outliers if you’re using MAE to place stops because you lose more than is gained by trying to catch them all.
It may be, though, that a risk aversion factor may be too high to allow the loose stop placement that this statistic might suggest. You might be better off in another endeavor; and this leads us to the last word in the doctrine of cutting your losses: “short.”
THE RIGHT BUSINESS?
Short is relative. In other words, the term, no doubt, means different things to Yao Ming and Mickey Rooney. A short loss to you might mean $100; to a professional fund manager it could mean $100,000. Note, however, that it is not only a matter of resources but a matter of time frame.
Until you can define this term for yourself within the environment in which you operate, you will have a difficult time turning a profit. Unfortunately for most traders, they treat this as guesswork, at best.
Whether you have successfully cut a loss short or not depends on how much money you have at risk and how much of a drawdown you are willing to stomach. It depends on the time frame in which you trade. A fixed $500 per-lot stop loss on a daily bar chart represents a fraction of the same percent loss in a five-minute environment.
It depends on the position size you are able to handle with the resources you have.
The bottom line is that some of the most innocent sounding maxims that have seeped into our culture can lead to disaster if not applied carefully. As a trader, you owe it to yourself to break down these pearls of wisdom and evaluate them for what they are at their core. Your future profitability depends on it.
Raleigh Lee is a private investor. He has more than 20 years experience trading futures, indexes and forex. He is a partner with Brian Lee in LongView Investment Trust LLC, a currency trading firm in West Palm Beach, Fla. He is in charge of systems development. Brian Lee has 11 years trading experience in commodities and forex. He is in charge of education and marketing for LongView. E-mail them at brl@marketallies.net. Web: www.harooki.com.
