Don't Neglect Your Exits  

By Chuck LeBeau

Futures and options traders have always had to be concerned about exit timing because futures contracts and options have a very limited holding period prior to expiration. Stock traders on the other hand have not been faced with this problem and may have become complacent about their exits. With the increasing volatility evidenced in the stock market recently we think that stock traders will benefit greatly from an increased awareness of the importance of good exit timing.

Those who have read our book and followed our work over the years will recall 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 the entry determined the outcome of the trade. This assumption might be true for a buy and hold investment but this is definitely not the case for traders. System traders in particular will find entries have very little influence in determining the result of a system. 

In the System Building workshops that I teach with Dr. Van Tharp, we play an exit game where everyone enters a series of trades at the same price and then each student implements their own exit strategy as new 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 is rare for any two players to have the same results and the point of this simple exercise is to illustrate the effect of exits on our trading results. In this game everyone has identical entries yet the final performance of the simulated trading ranges from large losses to large profits. (read more.....)

The same is true in actual trading. Exits determine the outcome of our trading far more than anyone realizes. In fact our research shows that exits have more impact on the results of a system than any other factor, including 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 first observed the impact of exits years ago when attempting our research of popular indicators we were testing as entries. We found that even a minor variation of the exit strategy would drastically affect the number of trades, the size of the winners and losers, the percentage of winners, the size of the drawdown and the total profitability. Although we set out to test entries, we quickly discovered that the performance data was entirely dependent on the exits we used and the entries had little if anything to do with the results.

To make our research more meaningful we eventually began isolating, as best we could, the testing of entries and exits. We now evaluate our entries based solely on the percentage of winning trades they produce when exiting after a specified number of bars. This method of testing entries evolves from our conclusion that the primary purpose of entry timing is to get the trade started in the right direction as accurately as possible. Everything that happens after the entry is determined by our exit strategies. Ideally we want our entries to accomplish only one purpose and that is to get our new trades started in the right direction as quickly as possible. This function is easy to measure and the higher the winning percentage after a few bars in the trade, 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 better quantify the relative merit of various exits we created the Exit Efficiency Ratio and several years ago we contributed an article on this topic to Futures magazine. 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.

Those of you using Omega's Portfolio Maximizer software you will recognize that the Exit Efficiency Ratio utilized in that program is quite similar except that it varies from the original formula in one important feature. The Portfolio Maximizer formula measures only the efficiency during the actual holding period. I suspect that this modification is for practical reasons because the trade by trade data used for the Portfolio Maximizer calculations would not include any data that was outside the time period of the actual trade.

When calculating the best theoretical exit point, the doubling of the holding period is critical to evaluating the exit fairly because most traders are inclined to 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 let's 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 reaching a new peak. Measuring only the duration of the actual trade would incorrectly credit us with an exit that was 100% efficient without any penalty for closing out the trade much too soon. 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 us for exits that were more profitable but were implemented after the peak. 

For example if the open profit sequence for each bar were $500, $800, $1000, $1500, $2,000, and $1700, an exit at $1000 would appear to be more efficient (100%) than the more profitable exit at $1700 (85%). 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.

Unfortunately the Exit Efficiency Ratio can only be applied to profitable trades and applying it to your trading and research will require some additional effort and record keeping. Whether you use this valuable calculation or not, we suggest that emphasizing and improving your exits is the quickest and most effective method to improve the performance of your system.




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Last revised: June 17, 2008