I thought I would follow up on the question of trade management and how it can impact on trading results/performance. To do so I am going to use an example from FX trading, although the ame principles can be applied to equities trading as well.
Because I don't want to focus on the setup/entry, I'm going to choose a very simple gap strategy as shown in the following diagram (See below). This is based on the daily timeframe and I am going to use a currency pair (the GBPNZD) which I know gaps at the open of the day's trade farily regularly.
So the entry strategy will be pretty simple, consisting of the following rules:
If the market gaps down on open, I am going to buy 1 position of 0.1 lots (an FX order volume measure, equivalent to approx $1/point)
If the market gaps up on open I am going to sell 1 position of 0.1 lots
The gap must be a minimum of 10 points (otherwise its just not worth the trouble)
Those are my only entry rules. Its a single entry strategy - I could add aditional positions, but I want to focus on trade management rather than on the criteria for additional entries.
Now I am going to focus on managing the trade from there, using several different options, and show what impact those options have on the results - I will show the results of applying the strategy over a 3.5 year period (remember this is the daily timeframe we are trading on) using the backtesting software that is available as standard on the MT4 trading platform (used for FX, commodities and indices, not equities).
To start with, I am going to try a very imple gap strategy:
I will place a stoploss at the low of the day's bar that just closed for a buy, or at the high for a sell
I will place a take profit order at the close of the previous bar, i.e. the aim is simply for the gap to close (or hit the stoploss)
The following are the results for this currency pair over that 3.5 year period, using the above as the most basic strategy:
So the above results are not too shabby. It makes a profit of over 20% in 3.5 years, and the maximum drawdown was $635. And this approach has a win rate of 86% - that's very very good.
Now I notice from my charts that when this market closes its gap, it often keeps going, so I wonder if rather than simply setting my take profit to close the gap, what if I set the take profit at 2x, 3x or 4x the size of the gap? I am going to be greedy and I am going to set the take profit at 4x the gap size (and the stoploss remains at the high or low of the bar before the open, for sell and buy respectively).
Now the results are as follows:
So being greedy has paid off, I've increased the return from about 22% to almost 32%, and the drawdown has only gone up about $150 to around $800. Thats pretty good, but now I look at this curve and think its pretty choppy - there are clearly short periods when the strategy doesn't work well - and I notice that the win rate has dropped to around 73% - 13% lower than with the initial strategy.
So let's try another option. Now instead of setting a take profit target based on the gap size, I'm not going to have a take profit and instead what I am going to do is use a trailing stop so the only way to exit is when price hits the trailing stop.
Ouch - the following are the results using this trailing stop method:
Ok so I've managed to turn a winning strategy into a losing one (a win rate of only 23%!!!) - what a blockhead I am! But rather than be harsh on myself, I take a bit more of a look at the trades and I realise that many of the trades are closed if not in the same day, then the next day - only a very small number last more than 2 days - so a trailing stop is going to be very ineffective in that kind of situation (they are better suited to trening strategies which the gap fill strategy is not).
Ok, so I've tried 2 of the most obvious stratgies, and given the new information above about how long gap fills stay open for, I am going to try the following:
I am going to return to using a tak profit based on a multiple of the gap size - and because of backtesting I've done previously, I'm going to choose a take profit of 2x the gap size.
Rather than set the stoploss to the high or low of the bar before the gap open, I am going to choose a fixed point stoploss - taking a look at the charts I can see that even though with the first strategy the win rate was 86% - quite regularly when the market gaps on open, it will break the previous day's high or low. So I will choose a try a fixed point stoploss at a distance of 60 points - which is less than the average daily range but maybe enough to give the strategy room to move before it hits its target.
So I'm being a bit les greedy than the 4x gap target, and giving the trade a bit more room to move - hopefully I will get rewarded.
The results are:
Now this is a beautiful equity curve. And by opening up the risk original parameter slightly and not being so greedy with the target, I have found that the stratgy actually works significantly better. The return has increased now to 47% and the maximum drawdown has actually reduced to around $350. The win rate is not quite as high as the original simpler strategy but its still almost 80%. So basically a few less wins but the average win is slightly more.
There are more options I could go through, especially if adding additional positions, or considering other types of strategies (eg. breakout, trending, reversal), but I thought the above would provide an insight into what impact trade management has on trading performance for a give setup/entry - the trade management can change the outcome from -14% using one technique to +47% for a better suited technique - without fussing over the entry at all.
