Riding A Great Trend? Know When To Get Out

Most traders have heard the adage "The trend is your friend" at some point in their careers, but they would be wise to think about the second part of the title of this article before blindly taking trend signals.

Trading with the trend is certainly one of the most important trading principles to understand and practice--whether that means using a long-term trend-following system or a shorter-term approach that simply finds swing entry points within an already existing trend.

Defining trends and trading in their direction is relatively easy. However, it's only one part of the story. Getting in the market on the side of the trend is one thing, but if you don't know how to get out with a profit, it doesn't do you much good.

With the Internet giving traders unprecedented access to market information and trading advice, it's sometimes difficult to sift through all the trading strategies and concepts at your disposal. Numerous advisory services that suggest which stocks or commodities to buy or sell, but most of them place little emphasis on where to exit trades--a critical element of successful trading.

We will take a look at the principles of trading with the trend, but more importantly, we will explain the importance of timing your exits. In other words, it's not just trend-following, it's how you do it that counts.

Trend-following approaches

There are numerous ways to identify trends and trade in their direction. Two of the better-known basic approaches are the moving average crossover approach and the channel breakout approach. Both of these approaches identify trends after they have started and take (usually longer-term) positions in their direction.

The moving average crossover method buys when a shorter-term moving average (say, 10 days) crosses above a longer-term moving average (say, 40 days) and sells when the shorter-term average crosses below the longer-term average.

The channel breakout system buys when price exceeds the highest high of the last N days and sells when price drops below the lowest low of the last N days. For example, a 40-day channel breakout would go long when price exceeded the 40-day high and go short when price exceeded the 40-day low.

These approaches are basic; you can use a number of techniques to improve their performance (avoid false signals, etc.), such as adding a confirmation rule that would require the market to stay above the breakout level for a certain number of days before taking a channel breakout buy signal.

Timing exits

This is where you have to start making some important decisions. The trend-following methods described above are valid as long as you keep the profit objectives in line with the system's characteristics. This simply means the system's average profit must be significantly higher than the system's average loss. A profitable medium- to longer-term trend-following system could easily have fewer winning than losing trades (perhaps 35 to 45%), but the average winning trade is much larger than the average losing trade.

What does this characteristic boil down to in practical terms? If you take profits too quickly on your positions you will greatly reduce your chances of success (bringing up another old adage: "Let your profits run"). So when traders are considering a particular trading strategy, they should first study the characteristics of the approach's losing trades and determine the average loss. If the strategy does not produce average winning trades larger than the average losing trades (a 2:1 average winner/average loser ratio, for example), it is almost sure to fail--even if there are more winning trades than losing trades. Let's use an example to illustrate this point.

Market examples

Table 1 shows the results of trading Intel Corp. (INTC) and Applied Materials (AMAT) stock from January 1, 1996, to March 16, 1999, using a simple channel breakout system. To enter a trade, we used a 40-day high to trigger a buy, executing the trade (100 shares) on the next day's open.

Then, we tested a number of exits to see how they affected this basic approach. For example, in Table 1, if we exit our long position when Intel closes below the low of the last two days, the net profit would have been $345. The most important characteristic of this table is the distinct pattern of deteriorating results that accompanies increasingly shorter exits. ("Profit Factor" in these tables refers to the gross profit of the test period divided by gross loss.)

INTC: Channel breakout	AMAT: Channel breakout
(1/1/99 - 3/16/99)	(1/1/99 - 3/16/99)
Exit Length Net P/L Profit Factor 2 345 1.06 4 -1185 0.81 6 26 1.01 8 1995 1.45 10 4710 2.38 12 7001 6.27 14 7326 6.01 16 7000 4.92 18 7007 4.92	Exit Length Net P/L Profit Factor 2 -2631 0.33 4 -1179 0.65 6 1832 2.05 8 2001 1.99 10 3356 3.18 12 3137 3.14 14 2781 2.67 16 2953 2.99 18 3146 3.12

Table 1. Performance of 40-day (entry) channel breakout systems with varying exit lengths for Intel (INTC) and Applied Materials (AMAT).

The important message from these results is that you must be willing to hold positions to make large profits on them. If you take profits too quickly, you are doomed to disappointment. (Oddly enough, this contradicts yet another bit of market wisdom: "You can never go broke taking a profit.")

Figure 1. Channel breakout with 20-day low exit (AMAT). Source: Omega Research.

Figures 1 and 2 show the difference in trade frequency between a 20-day exit and a 5-day exit in Applied Materials (AMAT). The benefits of the longer exit are immediately apparent from these charts. Look especially at the up trend captured on both charts: The five-day exit would have taken you out of the market early (and repeatedly, if you had continued to re-enter long positions), while the 20-day exit took better advantage of the price move.

Table 1. Channel breakout with five-day low exit (INTC). Source: Omega Research.

Day trading

Another point to consider is that the concepts outlined here do not just apply to trading daily data. Because we also can find the same patterns in intraday and weekly data, day traders (as well as very long-term trend traders) should pay close attention to how they time their trade exits. No matter what time frame you're operating on, you have to trade in such a way that you get the most out of the available price moves.

These results are interesting in light of the current stock market environment and the day trading community that has emerged. Many of these traders reason that because online trading commissions are so low, they can trade much more frequently. I strongly suspect these traders would be very surprised to learn that keeping your profit objectives in line with your trading style is much more important than trading frequency.

Taking quick profits on trades can be very dangerous if you do not take into account the nature of your trading methods. A prudent approach might be to take only partial profits in the early stages of a trade, keeping part of your position to capture any subsequent price move.

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