A profit target also could be used as an end-of-event exit. This happens when
the anticipated magnitude of the move is reached before the maximum allowed
trade length. In that case, it is not unlikely that the market has overextended itself
in the short run, and it could be a good idea to take a profit with a limit order, and
then enter anew after the market has retraced parts of that move.
The fourth reason is that the money invested in the trade could be put to bet-
ter use elsewhere, no matter the performance of this trade. Obviously this is the
case with a trade that goes against us, but this also could be a good reason to exit
a winner, if you also monitor and trade several other markets and systems. If
you’re in a slow winner, this could be a difficult exit to execute, but remember that
your research has told you what to expect from a trade. While there is no way to
know how a future trade will develop, at least you have a clear picture of what you
want out of it, and while a future trade still has to prove itself, a slow trade already
has proved itself to be just that—a slow trade.
The most straightforward way to calculate where to place your stops and
exits is to calculate the most opportune percentage distances from the entry price.
The major advantage with this method is that it doesn’t add any new optimizeable
variables that complicate the rulings for the system and detract from the robust-
ness and reliability when traded on future data.
The major disadvantage is that it is rather static, which will alter its per-
formance with the volatility of the market. If the volatility is higher than average,
the system will have you stopped out with a loss more often than necessary, while
at the same time taking profits too soon, given the potential of the move as induced
by the increased volatility. If the volatility is lower than average, the profits will be
smaller than normal and more trades will be stopped out by the time-based stops.
To come to grips with the volatility changes over time, another way to cal-
culate where to place the stops and exits is to use the average true range method.
Using this method, you always let the trade move with or against you with a pre-
specified number of true ranges. Because the true ranges will vary in size with
the volatility of the market, so will the distance between the entry price and the
exit points.
The major disadvantage with this method is that it needs historical data for the
true-range calculations, which complicates the system and makes it less robust. You
can work around this by setting the lookback period for the true range equal to either
the lookback period for the rest of the indicator or pattern, or to the maximum
allowed trade length. Personally, I prefer to go with the maximum allowed trade
length, and then test the trade length and the lookback period for the true range
simultaneously. As already mentioned, the maximum allowed trade length shouldn’t
differ that much from the lookback period for the indicator or pattern, anyway.
The best way to find the most optimal input-variable combinations is to ana-
lyze them using a surface chart, in which the color of the chart indicates the value
of the output. Once you’ve learned to interpret the information in a surface chart,CHAPTER 23 Evaluating Stops and Exits 283