The two other critical features of any trading strategy

You have found good entry signals for your strategy. You are off to a great start! Now you can focus on the two other essential aspects of any trading strategy: exit strategies and the money management, .

How do I do that?

In order to illustrate how this is of crucial importance, we will take a basic sample, say, a channel breakout strategy (go long when you cross upward the highest high of the past n days, go short when you cross downward the lowest low of the past n days) in which we exit and go flat when we cross back a moving average.

If we apply this strategy on two assets, the CAC 40 and the Crude Oil futures , we obtain the following results (Algodeal score card):

These results are promising, it produces some good results, but after a complete analysis, no funds would be allocated to this strategy because it appears to be too risky and unstable from one year to another.

First Improvement: dynamic allocation between assets

Now let’s change the allocation scheme: instead of weighting equally between the two assets, we are going to include a measure of volatility when calculating the quantities to buy or sell, with an idea directly inspired by common sense: the riskier the asset, the lower we will be exposed to it.
To do so, we just moderate the number of contracts bought or sold by the value of the Average True Range (ATR) of the last 2 days as a percentage of the last close. This number will thus tend to allocate more if the short term volatility is lower with respect to the closing price.

The results obtained are very different and much improved on the previous ones. The annualized Sharpe ratio reported at 0.41 is far better than the first one (0.28), using the same strategy apart from the allocation mechanism.

Second improvement: how do I better exit a position ?

Now we consider another aspect of the strategy, which is how we exit a position. We often want to monitor and control what amount of money we are willing to lose when entering a trade. To do that, we usually consider fixed stop loss and profit levels. In our case, we will first set a 5% stop loss and 10% profit target. In this case the simulation gives us the results reported below

The results are disappointing. We might have cut our profits too quickly, or maybe the stop loss is too close to the entry price. One way to counter this is to consider adaptive stop loss or target profit levels. Here again, we include the ATR value into the calculation of those exit levels, in order to take into account short term variation of the prices, and we observe the following results:

We observe radically different results . The stategy became profitable, just by applying adaptive levels of an adaptive exit strategy.

Conclusion

As we briefly illustrated in this page, both the way you allocate money when entering a position and the strategy you choose to exit a position can greatly influence the results of your trading. These two elements are full parts of the overall trading strategy that must be studied before go live trading.