What We Learned About Trade Management After 4 Simulations On 200 Trades: by Justin Paolini

“It’s not about being right, it’s about making money.” – Scott Ramsey, Market Wizard

Most retail traders think that profitable trading is just about picking winning trades. Hence the enormous focus on entry techniques. However, the devil is always in the details. When traders are studying past price charts looking for setups, what they don’t keep in mind is that each minute of each hour of each day they cast a cursory glance at, if confronted in real time, could generate a multitude of doubts and questions about whether to hold or fold the trade.

Timing has it’s importance within the components of a good trade…but it’s much more important to manage the trade correctly from start to finish. After going through 200 of our own trades, we’ve got some ideas about what works and what doesn’t.

The Importance of Trade Management

“You have to trade at a size such that if you are not exactly right in your timing, you won’t be blown out of your position. My approach is to build a larger size as the market is going my way. I don’t put on a trade by saying “my god this is the level; the market is taking off right from here.” I do the same thing getting out of positions. I don’t say, “fine I’ve made enough money. This is it I’m out”. Instead I start to lighten up as I see the price action or fundamentals changing” – Bill Lipschutz, Market Wizard

To a certain extent, profitable trading is actually about correct timing. If we enter into a trade anytime, anywhere, and simply hold that trade, the chances are that the trade will come back to our entry price or offer a profit sooner or later. Of course, the probability of this happening in FX is much higher than in Stocks.

Source: OANDA’s MT4 Open Order Indicator with Open Positions

But we cannot just hang onto trades, waiting for them to offer us a profit. What if the trade goes into the red by 800 pips…then comes all the way back and offers 5 pips worth of profit? Is that an efficient way to trade? In stocks especially, you might not even see your entry price again before reaching a margin call on your account! So you have to be right on your idea, and approximately right with your timing but that alone won’t be enough to win big in the market.

If your idea is correct, then your trade management will decide how much of a profit (or a loss) you will actually make, and whether it’s a viable proposition in the long-term.

200 Trades

“Having a beautiful idea does not get you very far if you don’t do it the right way.” – Colm O’Shea, Market Wizard

To study the effects of different trade management techniques, we analyzed 200 of our ownsignal trades, taken from July 1st 2015 to September 30th 2016. Here is what the real equity curve looks like.

This equity curve was produced by following entry & management techniques:

scale-in entries: our signals are issued consistently in time, not in space. So we are basing our trade call on the background conditions (i.e. trend and momentum) and not on any precise technical setup;
3 profit targets: we scale out of the trade at predetermined profit target levels;
additional scale-out or position squaring on intraday reversals or upon discretion;
trailing stop: we trail the stop loss as the trade progresses in our favour;
in any case, close at end of day.

Objectives in Trade Management

It’s clear from our rules that the objectives for our trades were purely short-term in nature. I’d like to highlight the fact that “making as much money as possible” is not a viable objective in trade management. Trade management objectives need to be connected to the time horizon for the trade. For retail traders, trading around a day job or trading part-time, it’s typically challenging to adopt a shorter term stance or follow the markets intraday. Instead, managing trades less frequently, or only at end-of-day, is more common.

Time constraints can become quite frustrating for retail traders because:

sometimes rolling over trades produces the best results;
sometimes closing trades intraday produces the best results.

However, it’s very difficult to know beforehand which objective will maximize returns. Of course, when there is a strong fundamental shift at hand, it may be worth holding on to the trade in an attempt to ride the potential trend for anywhere from a few days to a few weeks. But we don’t have that kind of situation most days, so is there a best way to manage FX trades?

That’s what we attempted to study. By changing the obejctives for these same 200 trades, we analyzed how the performance would have changed, in the search for clear observations that, more often than not, allow for a better outcome.

Intraday Objective with No Trader Discretion

The first iteration maintains the intraday objective: in any case, close the trade at the end of the day. However, we remove the additional scale-out or position squaring on intraday reversals or upon discretion. In this model, we either obtain our profit targets or we get stopped out, and in any case trades are not rolled over.

The first thing that sticks out is the superior performance of the limit orders. Without a precise entry setup, this intuitively makes sense: so long as we do not get stopped out, achieving an entry at a better price will result in higher rewards as we use the same stop loss for both the market entry and limit entry.
There is already something to be said about consistency vs. profitability: our limit orders were not triggered as often as the market orders, and our limit orders have a lower win rate. However, their performance is superior to that of the market entry. The limit orders had a 44% win rate and nearly +5R gains vs. +0.14R and 55% win rate for the market entries. This may also be due purely to mathematics: limit entries have stop losses that are usually 50% smaller than those on market entries.
The overall performance is lower than with trader intervention.
The drawdowns are higher than with trader intervention.

Multi-Day Objective with No Trader Discretion

This iteration changes the objective for the trades: by removing the end-of-day close, thesetrades can now be rolled over. This was an interesting test because sometimes our third target was not reached during the day of inception. So even if the trade was closed in profit, it was not as profitable as it could have been.

We are maintaining the no-intervention clause: our trades either hit their profit targets, or get stopped out.

Once again the limit orders show a superior performance if compared to the market entries. The difference is magnified now that the trades are being rolled over.
Despite being less profitable than the original system with trader intervention, the multi-day objective still offers higher profitability than the intraday objective.

Maximizing Momentum

This iteration keeps the multi-day possibility, but changes the objective slightly: by adding a more aggressive trailing stop, these trades are now attempting to maximize momentum.This was an interesting test because it demonstrates how rare it is, in FX at least, to have strong multi-day momentum.

For this test we used the following rules:

aggressive trailing stop: at each profit target, trail the stop by the [target – entry] distance. In practice this means that if we reached our second target, the trade was either at breakeven or with a small profit locked in;
market entry only;
no trader intervention;
3 profit targets;
no end-of-day close.

The results speak for themselves: the model is no longer profitable, if managed this way. There are a couple of instances where this trade management concept demonstrates it’s potential (between trades 100 and 140) but it’s evidently not a logical compliment to our trade selection and execution parameters.

What the Results Tell Us

Here are our conclusions, which of course are being incorporated into our signals in the attempt to strengthen our performance.

Trades need to be given time & space to develop: by closing trades at the end of the day, and by trailing the stop aggressively, the potential upside of a trade is very limited. Big winners take time (days) and space (volatility) to develop. Since we cannot hope to know ex-ante which trades will develop into multi-day runs and which will fall flat on their faces, it’s best to give them all the chance to spread their wings. This is also why a tight trailing stop caps profitability: the markets will make a move, then will come back to probe and test the resolve of traders. By trailing a stop intraday independently from the underlying conditions, it’s too easy to be unseated prematurely by a simple intraday wiggle;
Pre-determined profit targets offer higher consistency but lower profitability. It’s easy to understand this: when the trade moves in the right direction, you’re scaling out and diluting profit potential. When the trade moves in the wrong direction, you’re taking the full hit. This is the exact opposite to what sound trade management is supposed to achieve: smaller losses and larger rewards (which was incidentally demonstrated by the less reliable but more profitable limit entries).
Our multi-day tests did not incorporate a trailing stop: the rationale was that when trades perform well, 2 of our targets are hit intraday so the position we are running is in fact very small. By incorporating a trailing stop of some sort, surely we could have enhanced the profitability of our system a tad, but the impact would be marginal unless we removed the targets and were carrying a full position.
There’s something to be said about entry efficiency: in our signals (and hence in our iterations) there was no entry setup. Trading systems are usually built using 3 components: instrument selection, entry setup, trade management. In our signals, we are completely missing an entry setup. While this demonstrates how entries really aren’t the most important piece of the puzzle, the performance of our market entries has shown us that there is definitely space for some kind of simple trigger.
There’s something to be said about trader experience. None of the automated systems could beat our real equity curve (phew!). To a certain extent, this shows that relevant experience can assist in making good real-time decisions. All of this analysis is appealing and fascinating, but remember that when you’re trading the markets in real-time, each decision is much more difficult and only through time-tested experience can traders hope to make sound decisions.

Over to You

I cannot thank our Excel guru Pater Kolf enough for his help with this project. What has emerged will definitely help the average retail trader enhance his trading results. Here’s why:

common retail traders focus too much on short-term market movements. Instead we have demonstrated that letting trades run is a more profitable endeavour;
common retail traders love to move their stops to break-even. Instead, we have demonstrated that aggressive trailing stops hurt more than they help;
common retail traders have trouble holding onto trades. Instead, we have demonstrated that having pre-determined profit targets limits the upside while maintaining the same downside;
common retail traders place too much importance on setups and entry techniques. While there is something to be said about this, it depends on the objectives (longer-term objectives don’t require such precise timing) and on the strategy (trend-trading can be profitable without any kind of entry setup as we demonstrated here).

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.