Trading Tips

Testing Trading Exits vs. Reversals

I’ve been reading a book of late that I will shortly be reviewing. There was a comment of the author’s that I wanted to address now, though. In talking about system testing the author made the statement that it’s better to run strategy tests based on position reversals (long to short, short to long) rather than position closures. It’s a statement with which I’m not very comfortable.

Now, to provide a little context, the focus here is mainly a longer-term investment one, so it’s generally looking at things from long-only perspective. That means a sell signal is an exit signal. It’s not really meant to be a short entry signal, though obviously there’s the potential for playing the short side as well. The author’s argument for testing a strategy as if shorts will be entered is that it will provide the best selling signals.

Here’s the thing, though. Good long exits are not necessarily the same thing as good short entries.

Pure traders, of course, have somewhat different considerations, but investors should be thinking about total return considerations. If the market is going to go sideways for a lengthy period, for example, it would be better to be out of your long near the start of the move into consolidation than it would be to wait until a short signal was triggered at the end of it. That would save a lot of emotional capital being wasted during a choppy back and forth period and provide the opportunity to put the money to work in a way which would actually provide a return (fixed income investments, for example).

My point is that optimal short entries do not necessarily make optimal long exits (or vice versa). Of course, it always comes down to testing.

By John

Author of The Essentials of Trading

4 replies on “Testing Trading Exits vs. Reversals”

I am uncomfortable with the author’s position as well as your last sentence.It does not always come down to testing.

Exiting requires no longer wanting to own the current position.

Flipping to the other side requires far more than ‘not good enough to own.’

Mark – In the context of a system, which is the underlying discussion of this particular book, testing is an important element. I understand your point, but I would ask the question “What makes you no longer want to own the current position?” If this is something more than gut feel or motivated by non-trading/investing reasons (need the money, etc.) there is the implication of some kind of strategy implied in determining exit timing, which then implies the potential for testing.

I exit a trade when I no longer like the risk/reward. But that does not mean that the risk reward is so bad that I want to take the other side of the trade.

I’ll exit a trade when I have achieved my earnings target. Yes, I may re-evaluate and hold longer, but that is the exception, not the rule. Again, choosing to exit via this mindset represents no reason to take the other side of the trade.

I’ll exit a trade when I find something ‘better.’ By better, I believe I can earn more money (with equal or less risk) – from today into the future – with the new trade than with the current trade. Once again, no reason to go from long to short.

One more thought: Trade size is related to earnings prospects and risk prospects. Some trades are done in larger size and some smaller.

When I deem that the appropriate trade size is now $0, it is time to exit. If I took the other side, then my size would not be zero.

I have nothing against testing. However, if you discover that when you exit IS indeed the OPTIMAL time for entering a short position, then I would tell you that you held your original trade far too long.

There MUST be some area in which a specific trade is simply not good enough to enter either long or short. If there were no such area, then every possible trade would be a buy or sell at every conceivable moment in time.

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