The Importance of Exits

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how one of the best ways to improve your trading is to change your exits.

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

Today we’re going to talk about the importance of exits. We’ve been talking about the five components of trading. So let’s review them.

The five components of trading ranked by their order of importance:

1. Psychology

2. Money Management, or Position sizing

3. Market Selection

4. Exits

5. Entries

So today we’re going to talk about exits, and you can see in the five components exits fit in fourth. Now, when you look out in the general trading community, and you look at trader education and trader commentary, trader commentary and trader education revolves primarily around number three, market selection, ie what stock do I buy? And number five entries, Is this a good time to buy the market? Is this a good time to buy the stock? But you rarely hear psychology talked about, you rarely hear money management talked about, and you rarely hear exits talked about. So when we look at the five components, what’s interesting is the top two barely get talked about at all, and number four doesn’t get talked about either. So three of the four most important components of successful trading are not talked about.

So today, we’re going to talk about exits, and we’re going to talk about the importance of exits. Why it sits at number four, instead of number five. When we talked about the importance of exits, there’s different aspects that we want to talk through. First of all, one of the key aspects is that exits are psychological. They’re highly psychological. What does that mean? That means that once somebody gets into a trade, they are fully vested in it psychologically. I’ve been around this for a long time, I’ve taught people how to trade. And what’s interesting is, if I give people a system, I say, here’s a box right here in this box, is everything you need to do to trade successfully. It tells you where to get in, it tells you where to get out. And I give that to a group of 20 traders, what you’re going to see is that a high percentage of those 20 will follow the entries, they will follow the criteria of how they find it, and how they get in. But once they get in, the whole thing diverges. Now, why is that? Before we get in, we’re not psychologically invested. It’s just an idea. But once we’re in, we have real money on the line, and our psychological beliefs come to the forefront, and now are going to color our decisions.

You learn the system in a box, you enter by the rules, but the exits. You now start to question the exits, and it might just be a solo thing. It might be like the trade works, and all of a sudden you have fear that you’re going to give the money back. So you jump and get out. Some of them, the trades start to be a winner a little bit and you get out other people be like “No, I don’t want to get out I’m going to ride this is for as long as I can.” Some people will sell a little bit, some people will sell a lot. So if we buy 10 contracts for our position size, well, some people will sell one, some people will sell five, some people will sell 10, and so by the end of the trade, you have 20 Different P&Ls. Isn’t that interesting? Isn’t it interesting, that when you give somebody a system, you give them a method, the entries will look similar, the exits will look different. That’s why it’s one of the big reasons why exits are so important because they really reflect your psychology.

If your psychology is bad, it’s going to get reflected in bad exits.

Now another aspect of this is when you go through and you look at great traders. The thing that you’ll see that great traders have in common is they’re awesome at exits. They get out in ways that nobody sees or nobody knows. They act very disciplined. They have great timing for when to get out.

There’s a famous book called reminiscences of a stock operator, and It’s the story of Jesse Livermore. It’s a fictional story about Jesse Livermore, and the big thing I got out of that book, the first time I read it, there are lots of big traders who all recommended this book, the big thing I got out of that book was that for the average trader, they buy when they want to, and they kind of sell when they want to, because their sizes are small, so they’re kind of insignificant to the market. But when you start trading really big, like Jesse Livermore did, or you start trading really big, like a fund manager does, you start trading really big, like a market maker does, like I’ve done in my career, both as a market maker and a fund manager, you start to get into these positions that you are really big in the market. And when you’re big, everybody watches you. Everybody watches what you do, and when you want to get out, when you start to sell to get out, everybody will start selling in front of you. They’ll try and race you, and they’ll make you hemorrhage money trying to get out. So in reminiscences of a stock operator, the lesson was, when you have a big position on, you get out when you can, not when you want to.

I’ll say that again, you get out when you can, not when you want to.

What does that mean? What that means is that when you have a big position on, you have to sell it, when there’s demand for it. If you wait for the market to roll over and turn down, the demand will disappear, and you will hemorrhage money trying to get out. If you get into a situation, you’re long, and now there’s a party who’s bidding and bidding and bidding, trying to get it bought, that is your opportunity to sell it to them. Because in that moment, that party is focused on what they’re trying to do, they’re focused on either the greed of getting in, or the fear of getting out, like just get me out of this position and take my loss. But soon as that party’s done, there’s going to be a vacuum. This is what we talked about a couple of our Facebook Lives this week, we talked about buy the rumor, sell the fact and how a market top goes in.

There will be a vacuum.

If you don’t sell you have the opportunity, you’re going to be caught in the vacuum and you’re going to sell it in the hole. So this is that’s a key component of exits.

Exits also reflect your objectives. A lot of times we talked about objectives. I know for me when I first heard this, I’m like, what does this mean? I just want to make money. But what objectives are, is what is it that you’re trying to accomplish? How do you want to make money? Do you want to make money with a nice smooth equity curve? Or do you want to make money with an equity curve that might be volatile, but it goes parabolic? They are two different outcomes. One is designed to make money in a conservative, steady way, and you will never make the most amount of money there. The other is very volatile. But that’s where the most money is made. So what do you want? The type of exit you use help reflect your objectives.

Another key element about exits is everybody uses stops, and we want to understand that stops kill performance.

This is one of the biggest misnomers in trading every retail trader wants us to stop because that stop makes them feel safe. But the reality is stops kill performance. They take you out of your best trades prematurely. We’ll show you some stats on this in a minute.

Then I like to talk about there’s two types of exits. There’s money management exits, and there’s tactical exits. Nobody talks about the money management exit, barely at all, but what a money management exit does is it helps you set exits around your objectives. If the risk gets too big and you want to smooth your curve you’ll sell some or if you want to amplify your curve the risk won’t get too big you’re gonna look for opportunities to add risk to make your curve go parabolic. Two different sets of objectives two different types of exits. Now, so we have money management exits, which are rarely talked about and we have tactical exits.

Tactical exits are talked about all the time. So this is do you use a trailing stop? Do you sell high? Do you sell a divergence? Do you sell in volatility extremes? Do you sell on time? Do you sell on an environment condition? All kinds of different types of exit you could choose which ones are you choosing and why? Are you using it because you read it in a book or you’re using it because you really thought it through?

The last aspect is that using options can really help create better exits. So we talk a lot about it in our workshops, about how to use options to optimize your exit. Again, no surprise, it’s going to loop back and come back to objectives. Do we think the trades gonna keep going and we’re trying to get risk off the table? That’s a lot different objective than we think the market could imminently reverse and go south. Two different sets of actions. Options to help in both these scenarios create much better exits, than you’re going to get just getting out of stock or futures alone.

We talked about this concept of stops kill performance. I’ve done a lot of work over the years of Larry Connors, I’m actually a small partner in one of his companies, and Larry published this work, which I love, which is that stops hurt. You can see what he says here, for many years, I advocated the use of stops in trading. If you look at any of my published work up until 2004, you’ll see the words ‘use stops’, alongside most strategies, but early 2005, when running tests, with the hope of identifying the optimal stop level to use, what came back was completely the opposite of what they imagined. And what it was is, after running hundreds and hundreds of tests, at different stock levels, they all came to the same conclusion was that stops hurt performance. He had a table here that basically showed the size of the stop, and the average profit per loss and the winning percentage. Notice here, if you had no stop at all, trade made about .58%. It was a winner 70% of the time. But soon as he started to implement a stop, so he put stops 1% away, his average profit went to .19%. And look at his win rate, it collapsed to 27%. The system got destroyed by this. You can see, as he makes the stock bigger and bigger, the average profit to loss ratio starts coming back, and so does the win rate, but it’s not until you get all the way to a 50% trailing stop that the numbers actually look like having no stop. We’ve seen this over and over and over again, it’s very, very rare that I see a test where stops actually help. I have seen a couple but very, very rarely.

One of the strategies that we teach in our Matrix Money Machine. It’s called the BB Gun, and the the BB Gun, you can see here we have two different samples, one run with a stop and one run without a stop, you can see the sample with a stop as a 50% win rate and expectancy of 85 cents. The average win to the average loss is 2.7. This is an excellent system by the way. But if we take the stop off, our expectancy goes up by basically about 25%. The improvement comes at the wind rate because the wind rate goes 50% to 66%. The average win to average loss actually goes down to one and a half. But it’s made up by a significantly higher win rate showing that stops do hurt performance.

I do actually use stops, but I actually love to use options and places stops because options give you optionality. So when you get to your risk point, you don’t have to get out, the market can come back. Or if you do want to get out you can get out on your own terms, rather than being forced to exit, which is a huge thing. So I do try and set up trades where I either use an initial stop to protect my capital and then I stay out of the way or I use option trades that contain my risk so I don’t need to stop.

I’ve given you a lot here to think about.

You want to improve your trading. One of the best ways to improve your trading is to change your exits. Understand why you’re using the exits you do and get them optimized in a way that works to support you. This is a different mindset that will really pay off for you if you use it.

We just started a Red Pill Challenge. If you go to our Facebook Page Trading Matrix, you can see a link there, you can sign up or you can go to the tradingmatrix.com webpage, and you can sign up right there. We have other workshops coming up as well. We’ll be doing another matrix money machine in April. And I encourage all of you to continue to tune in to trigger Tip Tuesday, every Tuesday. And you can see is that our Facebook page and Trading Matrix where I do a live every night where I share tips similar to what I’ve shared with you today. I won’t waste your time I will give you great content that will make it worth you hanging out with me. So I hope to see you in a Facebook Live or next week on Trader Tip Tuesday and I especially would love to see you in a workshop where I can really meet.

So have a great week. God bless. I’ll talk to you soon.

~Chuck Whitman