Option Investor
Trader's Corner

Where's the Exit?

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Early one morning several weeks ago, one of CNBC's "Fast Money" commentators warned that it's possible to devise the right trading strategy but employ it at the wrong time. Traders who hold on as markets move too far against them may soon run through their accounts. Without an exit strategy, they could be left without funds to trade the move when it happens, that commentator warned.

Options traders understand that warning. Having occasionally in past years been long an OEX option that expired worthless on an expiration-week Friday only to see the anticipated move happen the next Monday, I certainly understand it. That CNBC "Fast Money" commentator may have thought he was speaking to those trading stocks, but it's the options traders with whom his cautions most resonate.

His solution, his proposed exit strategy? I'm afraid it was a bit simplistic. Let the winners run and cut the losses quickly, he advised. That's an axiom we traders have all heard from time to time. It's also a valid exit strategy, if a simplistic one. I know the experienced traders among you can sympathize when I say that I've employed the opposite strategy a time or two, cutting winners short and letting losses run far too long. I don't advise that strategy.

Although the CNBC guy had the right idea when he quoted that often-mentioned trading axiom, he wasn't quite specific enough. What constitutes a "small" trading loss for example?

Later that same day, a seasoned options trader sent me the one-page exit strategy that he employs. He's a smart guy, with a well-thought-out plan that calls for him to exit partial positions on his credit spread trades if the play moves against him in certain ways. His plan includes specific percentages and amounts. It allows those credit spreads to work, to run, so to speak, while keeping losses small. His plan mentions his trading personality, factoring that trading personality into his decision of what constitutes a small loss for him. He calculated a loss amount that he felt appropriate for his account and devised a strategy that would keep losses at that level, barring some event that gapped prices so high or so low that he could not employ that exit strategy.

His plan had all the characteristics needed for a sound exit strategy. If you haven't revised your exit strategy in a while, it may be time to take a look at it again.

Factor the size of your trading account and your trading personality into your determination of the appropriate loss you'd be willing to take. A Trader's Corner article titled "Risk of Ruin" advocated that traders consider "risk of ruin" calculations, more typically employed by gamblers, to understand how too large a loss can run through accounts too quickly. Acceptable losses must be kept small enough that the inevitable series of losing trades that hits all traders won't run through the account. The article also explained that traders must factor their personalities into the equations. Losses that are too large for traders' comfort, no matter what the size of the account, can trigger panicked behavior. The article can be found at this link.

What constitutes a small loss may also depend on market conditions. When volatility began expanding in late February, traders likely had to adjust their exit strategies. A Trader's Corner article titled "Chandelier Exits" detailed how and why such changes might be made. The chandelier exit employs the average true range to determine exit levels, and the average true range expands and contracts as volatility does. A 1.5-point OEX stop might be effective when volatility is small, but might result in too many stopped plays that would have eventually been profitable in a more volatile market condition. Some traders choose to widen stops in such conditions. The article on chandelier exits can be found at this link.

I've heard from other traders who choose an opposite strategy. They tighten stops when volatility expands, accepting multiple tiny losses before they catch the right move. I don't know whether that's effective for some other traders or not, but I've found myself multiple-tiny-stopped out of a significant number of plays in a row before, and the ouch is just as big.

When I was still daytrading, I loosened stops, but if I got stopped multiple times, I stopped trading, reasoning that markets were not tradable or else that I just wasn't in tune with the markets at that moment. I waited for a tradable formation or trend before I reentered. An effective trading plan might also set up the number of losses that will be accepted before the trader retreats and regroups in addition to setting up the size of an acceptable loss.

Many brokerages or charting programs allow you to test your exit strategy. If yours does, I urge you to go through this exercise. It won't be the same as making the decisions in the heat of the fray, but that's what hard or trailing stops are meant to do. Write down your plan. Tell a trading buddy what your plan will be so you won't be so tempted to fudge on it.

Then the next time a CNBC correspondent urges you to keep losses small, you'll know exactly what a small loss is to you.

I wanted to let regular readers of this weekend Trader's Corner know that Jeff Bailey will soon be contributing an article on the Point & Figure charting that he knows so well. It should appear in this space within the next couple of weeks.

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