ply by putting on larger positions, possible thanks to the increased security of
the outcome.
To limit the possible outcomes for a trade, we need to think about the reasons
to exit the trade. Basically, there are four different reasons why we should no
longer stay in a trade. Of the four reasons to exit, two reasons are price-based and
two are time-based. Many times the reasons and methods intertwine, which makes
it all the more important to know what you’re doing.
The most obvious reason to exit is to limit a loss in a trade that goes against
us. For most traders this is easier said than done, and many times when we are lim-
iting a loss, we are doing so at the least opportune moment. It is important that the
loss is taken immediately and where it’s supposed to be taken according to the
strategy rules, so that we can free up the money quickly, put it to use elsewhere,
and leave all bad trades behind us as quickly as possible. Remember that the most
important thing isn’t to have as many winning trades as possible, but rather as
many winning time periods as possible. The best way to achieve that is to cut the
losers as soon as possible, so that we are left with as much time and money as pos-
sible to achieve that goal for each time period.
The second reason to exit is to make the most out of a favorable move and
take a profit. Basically, there are two ways to lock in a profit. The most straight-
forward method is to take the profit with a limit order as soon as it reaches a pre-
defined level. This is a good way to keep the standard deviations of the outcomes
to a minimum. If, in hindsight, it turned out you exited the market prematurely,
you are always free to enter again in this or any other market. The second way to
lock in a profit is to apply a trailing stop slightly below the current price (above
for a short trade). In this way you give back some of the open profit, but you also
give the trade a chance to capture that part of the move a profit target might have
kept you out of.
The third reason to exit is after it is fair to assume the market has discount-
ed the reason that triggered the trade in the first place. To measure this, we need
to get a feel for both the time horizon and magnitude of the moves the system is
most suited to capture. To calculate an exact number of bars to stay in a trade can
be very difficult, and it will alter depending on what type of system you have.
However, a rule of thumb is that a short-term system should not stay in a trade any
longer than the amount of historical data going into the system calculations to trig-
ger the move.
For example, if your system makes use of five days of historical data to cal-
culate the pattern or indicator that triggers the entry, in essence what you have told
yourself is that, in this particular case, the market has a memory of five days—
looking further back in time won’t improve the results for this entry technique.
Therefore, if the market has a five-day memory going into the trade, it only makes
sense it should have a five-day memory leading out of the trade, on average and
over a large number of trades.282 PART 3 Stops, Filters, and Exits