Imagine that I just made some trades. Imagine that I did all my research, I read the balance sheets and government reports, I spoke with experienced traders and analysts and I examined the price charts. Imagine that I bought Facebook shares, I sold Soybeans futures and I bought the Aussie Dollar/USD cross*.
What determines which of those trades makes money?
The answer has nothing to do with the fundamentals. It has nothing to do with the monetization of Facebook users, or the demand for Soybeans or the performance of the Australian economy. Whether my trades make money depends on one thing only:
How and when I exit the trades.
I have read hundreds of books on trading. I have spoken to hundreds of traders. Every day, I read dozens of blogs and news articles regarding trading and investing. The vast majority of the discussion revolves around how to enter trades. What to buy and sell, what to initiate, and why.
A huge amount of attention is paid to how, when and why to enter trades, and almost none on how to exit them. That is strange, since it is the exit, not the entry, that determines if a trade is successful or not. By choosing different exit strategies, you can dramatically affect the odds of a trade being a winner or a loser.
For example, it is very easy to dramatically increase your win/loss ratio: Simply exit a trade as soon as it shows a profit, and never exit if it shows a loss. Your win/loss ratio will rapidly rise towards 100%. Unfortunately, your overall profit will likely suffer dramatically: you will have a high number of very small gains, more than offset by a small number of very large losses (see Expectancy).
Alternatively, you can design a system that has a very high Average Win/Average Loss ratio: Simply exit a trade as soon as it shows a loss of any kind. You will end up with a large number of very small losing trades, which the small number of very large winning trades will probably not pay for.
For all the focus on entries, a system that uses a random entry can do surprisingly well. According to David Harding,
“If you put in stops and run your profits and trade randomly you make money; and if you put in targets and no stops, and you trade randomly you lose money. So the old saw about cutting losses and running profits has some truth to it.”
William Eckhardt told a similar story,
“Many systematic traders spend the majority of their time searching for good places to initiate. It just seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprisingly well with a good liquidation criterion. In contrast, random liquidations will kill the best system.”
As a trader, you need to consider how you exit a trade just as much, if not more, than how you enter it.
* Not recommendations. Not.