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Measuring Exit Efficiency

Those of you who have read our book and followed our work over the years will quickly recognize that we have long been outspoken advocates of the importance of good exits. In our opinion exits are much more important than entries yet the majority of new traders spend most of their time seeking the ideal entry strategy as if this would solve all of their problems.

 

In the System Building workshops that I teach with Dr. Tharp, we play an exit game where everyone enters a series of trades at the same point and then implements their own exit strategy as prices are reported to the group.

After about ten quick trials of this game the results typically range from one extreme to the other.

A few traders make a lot of money, a few lose a lot of money and most fall somewhere in between. It would be rare for any two players to have the same results.

The point of this simple exercise is to illustrate the effect of exits on our trading results. Everyone has identical entries yet the outcome of the simulated trading always ranges from big losses to big profits.

The same is true in actual trading. Exits determine the outcome of our trading and have more impact on the results than any other factor. Yes, exits are even more important than money management (position sizing). Not even the best money management strategy can make a losing system into a winner but a minor change in the exit strategy can work miracles. We quickly discovered this years ago when attempting our first tests of indicators. We found that even a slight variation of the exit strategy used in the testing would affect the number of trades, the size of the winners and losers, the percentage of winners, the drawdown and the total profitability. We set out to test entries but quickly learned that in most cases we were testing exits because the entries had little if anything to do with the results.

We eventually began isolating, as best we could, our testing of entries and exits. We now test entries based solely on the percentage of winning trades, exiting after a specified number of bars. This method of testing entries is based on our conclusion that the only purpose of entry timing is to get the trade started in the right direction as accurately as possible. Everything that happens after that has nothing to do with the entry because the outcome of the trade is now in the hands of our exit strategies. We want our entries to accomplish only one purpose and that is to get our trades started in the right direction as quickly as possible and this function is easy to measure. The higher the winning percentage after a few bars the better the entry. But how do we measure the efficiency of our exits? How can we tell if one exit is better than another? What is a good exit? What is a bad exit? Which is better: exit A or exit B?

To try and quantify the relative merit of various exits we created the Exit Efficiency Ratio and contributed an article on this topic to Futures Magazine several years ago. (I'm trying to get this Bulletin out today and I am sorry that I don't have the specific reference for the article in front of me.)

For those of you using Rina/Omega's Portfolio Maximizer software you should be aware that the Exit Efficiency Ratio that we wrote about is not the same calculation presently used in Portfolio Maximizer. Here is our original version of the Exit Efficiency Ratio.

You need to start by keeping or creating a record of your winning trades. You must also keep a record of the total number of bars in the trade from entry to exit. As an example, lets assume that we made a profitable trade that lasted 12 bars from entry to exit and the trade captured $1500 of gross profit.

The next step is to go back and look at our entry point and 24 bars of data after our entry. Our theoretical holding period is now twice the actual holding period. We then use perfect hindsight to identify the best possible exit point within this theoretical holding period. Don't be shy, pick the absolute best tick for the theoretical exit and compute the theoretical gross profit. In this case lets assume that somewhere in the period we could have exited the trade with a $2500 profit at the absolute high point of the theoretical trade.

The Exit Efficiency Ratio is then calculated by dividing the actual gross profit by the theoretical gross profit. We divide 1500 by 2500 to arrive at an Exit Efficiency Ratio of 60%. This tells us that we actually captured 60% of the profit that might have been possible for this trade.

The Portfolio Maximizer formula for exit efficiency measures only the efficiency during the actual holding period. I'm sure this is for practical reasons because the trade by trade listing used for most calculations would not include data outside the range of the holding period.

When calculating the best theoretical exit point, the doubling of the holding period is critical to evaluating the exit fairly because most traders err on the side of exiting their profitable trades much too soon. By extending the theoretical holding period beyond the actual exit bar we can see if this was the case. In our example we exited the actual trade after 12 bars and lets assume that the ideal exit point was on the 20th bar. If we only measured the bars in the actual trade our ideal exit point might have been on the 12th bar where we closed out our trade just as we were climbing to a new peak.

Measuring only the duration of the actual trade would credit us with an exit that was 100% efficient. The tendency of any calculation based only on the bars during the trade would be to reward us for exits prior to the peak and to penalize you for exits after the peak that might have been more profitable than the earlier exit.

By doubling the holding period in our theoretical calculation of the ideal exit point we can easily see if we closed out any of our trades too soon.

 

We typically use a combination of exit strategies and by giving each of our exits a name we can evaluate our exits individually or as a complete exit package. Some exits (like the Yo Yo exit) score better than others but since this can not be the only exit in a system we must evaluate the combination of exits as well as each individual exit.

By Chuck LeBeau
www.traderclub.com

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Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts