Are you familiar with trading’s great paradox?
It’s possibly the biggest contradiction ever. One that defies the classic principles of success.
You see, life often rewards us for persisting. From the classroom to the boardroom…the sporting field to the concert hall…staying the course can lead to greatness.
Trading is no exception.
First, you need to develop a strategy — this takes time. You then need to stick to that strategy when the markets don’t go your way. Giving up is a sure-fire way to fail.
Now, here’s the paradox…
A successful trader is also a serial quitter.
Yes, you read that correctly — a serial quitter. They’ll walk away from a losing trade without a second thought. Forget persisting. If it’s not working, get out!
Many people struggle with this concept. Instead, they doggedly hold losing trades in the hope of a rebound. But in this setting, refusing to give up can be a disaster.
I told you about the inexact science of trailing stops last week. While they don’t have pinpoint accuracy, an exit stop can make a huge difference to your results.
I’m going to explore this further in a minute. I’ll show you the results of some back-testing. You’ll see why I believe quitting is key to your success in the markets.
But first, here is a reminder of last week’s update…
A quick recap
Trailing stops are a powerful trading strategy. Not only can they help limit your risk, a trailing stop can also keep you in a winning trade for longer.
But they aren’t perfect.
Have a look at this…
You saw this chart last week. It shows a recent profitable trade in Webjet Ltd [ASX:WEB]. Quant Trader’s entry was in November 2015. The system then rode the trend for the next 12 months.
You’ll recall the red line below the share price — that’s the trailing stop. It tracks below the rising trend. The system sells when the shares touch the line.
Now, this was a profitable trade. But look at the exit. It’s right near a lasting low. This trade could have been more profitable if the trailing stop was a touch lower.
So, is this a failing of the trailing stop?
Not in my view.
Sure, exiting near a low is frustrating. But it’s also a reality. No one can consistently fine-tune their exits to perfection. You’ll only know how to tweak the levels in hindsight.
A member sent in an email on this topic during the week.
Here’s what they had to say…
‘Last week’s report was excellent. I really enjoyed it.
‘I agree that you have to exit when they hit your level. You can’t take the risk. Look at Bulletproof for example. We had 100,000 shares at about 35c. They went to 50c. The trailing stop got us out at breakeven. They are now 7c.
‘There are plenty more I can tell you where the trailing stop has saved my backside.
‘Well done Jason. Your system is a winner.
‘Keep up the good work.’
Yes, exiting a good trade early is frustrating. But holding a losing trade too long is worse. Earle’s account describes the primary purpose of a trailing stop — to protect your capital.
Check this out…
This is the stock Earle’s talking about — Bulletproof Group Ltd [ASX:BPF].
Quant Trader gave a buy signal in August 2015. The shares got off to a flying start. But the trend didn’t keep running, and the stock began to drift lower.
This is when the trailing stop is at its most valuable. It gets you out of a trade that isn’t working. There’s no holding and hoping for a recovery. The system cuts the trade without emotion.
As I said last week: Exiting weak stocks is key to the strategy’s success. I believe it’s better to miss a rebound than risk riding a stock all the way to the bottom.
But these are just two examples.
How effective are trailing stops on a bigger scale?
Let’s look at that now…
Quitting to win
One of great things about systems trading is back-testing. This is where you use historical data to ‘road test’ a strategy. The results are hypothetical. But they show you what’s possible.
So, here’s what I did…
I put two strategies to the test: The first doesn’t use exit stops, while the other strategy does (just like in the previous examples). The starting capital for the tests was $50,000.
Here’s the result for strategy one…
The simulation begins on 1 June 2002. It uses the same entry method as Quant Trader, and trades in $1,000 lots. The only difference is that there’s no company cap, and it only trades signal 1s.
You could call this a ‘buy and hold’ strategy. The system runs its winners…and losers. A stock only leaves the portfolio in the event of a takeover or delisting.
Now, at first glance, this doesn’t look too bad. The strategy turns $50,000 into $103,776 (before costs and dividends). That sounds like a reasonable result for the 15-year period.
But there’s a wide range of results. The best trade is a gain of 891%, while 15 stocks fall by more than 90%. Putting losing trades in the bottom drawer isn’t wise.
The strategy’s compound annual growth rate is 5%. By comparison, the All Ordinaries return is close to 3.6% per annum. Both the All Ords and the strategy’s equity are below their GFC peaks.
A robust buying method gives this strategy a slight edge. But there’s no plan for when a stock goes into reverse. Several big losses really hold it back.
OK, so what difference do you think exit stops will make?
Let’s take a look…
A plan to quit losing trades changes everything.
From a starting base of $50,000, the closing account balance is $258,856.
And remember, this uses the same settings as before. The only difference is the exit strategy (the system uses Quant Trader’s trailing stops).
This simulation has a compound annual growth rate of 11.6%. That’s an increase of 132% on the strategy that didn’t use exit stops.
No exit strategy is perfect. A trailing stop will sometimes get you out near the low.
And do you know what?
That’s OK — trades like WEB won’t ruin your portfolio.
An exit stop is for the stocks that don’t bounce back. These trades can be a big drag on your performance. They could even wipe you out completely.
Persistence can take you a long way in life. It’s the foundation of many success stories. Rewards often come to those who stick to their goals.
But this rule doesn’t apply to individual stocks. This is when quitting can pay. A willingness to cut losing trades is how some of the best traders make their fortunes.
Until next week,
Editor’s note: Exit strategy is one of the most important decisions you’ll make. Yet, despite its importance, selling is an afterthought for many traders. This can be a costly mistake.
Quant Trader uses a unique strategy to manage selling. The system’s algorithms tailor exit levels to each stock. This helps cull poor performers, while keeping you in winning trades longer. Some of the strategy’s wins include: Blackmores [ASX:BKL] +353%, Vita Group [ASX:VTG] +199%, and HUB24 [ASX:HUB] +147%.
So, if you’re not sure when to sell…I strongly suggest you check out Quant Trader.
Try it. See if it makes sense to you. It could change the way you trade forever.
Quant Trader sources all images and charts.