| When to Exit a Forex Trade |
by John Jagerson Now that we’ve discussed some of the factors to accounted for as you design the entries in your system, we need to spend some time on measurement. This is important to understand before you start working on exits.
The right place to set stops and trade exits, or initial profit targets in a forex trading system is often subject to two factors:
1. What risk the system itself will tolerate 2. Your personal tolerance for risk
Just because a system looks like it will be profitable does not mean that you want to trade it. If the stop loss potential is more than you can tolerate, or the trading frequency is too high, the system may disqualify itself from consideration, simply because it doesn’t meet your trading tolerances. The good news is, there are enough strategies and systems out there that all traders can find one that fits their needs.
Developing a stop and limit order, or profit target in a forex trading system can be tricky. The risk for over-optimization is very high. However, there are a few things you can do to identify whether that has happened. As we develop a stop and profit/exit target in this section we will be referring to the system rules that were developed earlier in this course.
We have found that developing stops and profit targets can be explained as a three part process. 
1. Use successful signals for estimating profit targets/exit points based on historical results 2. Establish a stop loss that allows for normal volatility but protects capital. 3. Test the system for performance and the dangers of over optimization Estimating an initial profit target/exit point When trading a more mechanical system, such as the one we will follow here, it is a good idea to have an estimate of how far you think the market may move during a typical successful trade. In the chart below you can see segments in time, "Trade 1" and "Trade 2," on the EUR/USD. The entry signals are shown as green arrows. An entry signal in this system is triggered when the CCI crosses above the -100 level, while the COT report indicates that investors are net long the currency pair itself. Over the periods I tested on this pair, the market was moving an average of close to 700 pips when the breakout went the direction I had forecasted. To be somewhat more conservative, I will test a target 10-15% less than that average move.
The chart above is an illustration of this part of the testing process. Every time a signal was generated according to the entry rules I had established for my backtesting, I would measure the subsequent move. Over the total backtest period, I found that 600 pips was a little below the average, which became my profit target for the system itself. The green area on the chart shows how that 600 pip target compared to the actual move after the green signal arrows in October and January. The chart shows how my estimate of a 600 pip move compared to the two different breakouts in Oct-Nov of 2006 and Jan-April of 2007. In both cases, the market moved slightly beyond my estimate. However, over the long term, I found that target to work well. This part of the testing process can be automated to a large extent. We will discuss how that works and how to avoid over optimization in the next section.
As you can imagine, a much longer period was actually reviewed to get a better feel for a reasonable average upside target. For testing purposes here, we will assume that the profit target is never changed but always left alone.
Setting Stops Stop losses can make or break a system. If you make them too tight, many positive trades will be missed due to whipsaws. This is a common problem among forex traders. On the other hand, if your stops are too loose, your overall profits will begin to dip as you lose efficiency in your losses.
To understand this issue, assume that you were trying to decide between a 75 pip and a 100 pip stop loss in a system that has a typical upside of 600 pips. The smaller stop loss may save you 25 pips per bad trade, but are you accounting for the lost opportunity cost if that smaller stop gets whipsawed?
Imagine that on a trade, the market moves down 80 pips, then takes off to the upside and meets your profit target of 600 pips. The smaller stop would have been hit, taken you out of the trade, and cost you 600 pips of profits. It will take you 24 more trades where you save 25 pips to make up for that one missed opportunity. So carefully consider the opportunity cost of tight stops.
Of course, you can only push this scenario so far before your stops become too big. The point of the example is to encourage you to be more liberal with your stops than you might naturally be. As we’ve stated before, you should only invest risk capital in the forex. That is, money you can afford to lose. If you can’t afford to lose it, keep it out of the volatile markets.
In the example above you can see that I have reviewed the system on a historical basis and decided that a 100 pip stop loss is reasonable for trades in this system. It provides enough room for the market to move following the signal, but protects my capital against larger declines, such as the one that happened after trade #2 in December of 2007.
The most common question at this point is how to determine the right stop size. It can be somewhat subjective but automation can also help. In the next section we will spend time on how the stop size can be tested for efficiency as well as over-optimization.
As in previous sections, the principle idea in designing a trading system is to plan ahead. If you know what your experience is going to be like when you enter the trade, it removes a lot of the uncertainty, and subjective analysis, which can create confusion and emotional reactions. Next: Avoiding Bias in a Trading System Keep up with us:
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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