Having well-planned
profit objectives is the best way to maximize
closed-out profits. The tendency is to either
take profits too soon or too late and most
traders tend to err on the side of taking
profits too soon. Taking a quick profit always
feels good and helps to maintain our winning
percentage because these "nailed-down" profits
will never turn into losses. However, taking
profits too soon can be one of the most costly
of all possible mistakes.
It has been argued that profits in trading
(especially in futures) are possible because the
distribution of prices is not normal and is not
a typical bell-shaped curve. The tail on the
right hand side tends to be surprisingly thick
indicating that unexpectedly large profits are
possible. The opportunity for large profits
comes our way more often than one might expect.
However if we went for big profits on every
trade we would also be making a big mistake.
Major profit opportunities are the exception not
the rule.
In very general terms there are two ways of
having an advantage or "edge" in trading. One is
to have gains much larger than losses and the
other is to have more winners than losers. To
succeed as traders we need to do our best to
maximize both the percentage of winners and the
size of the winners. These two worthy goals
appear to be mutually exclusive. If we take the
quick small profits we can have a good winning
percentage but we eliminate any possibility of
more substantial profits. However, if we fail to
take some of the small profits they may well
turn into losses.
Wouldn't it be ideal if we could know when it
was best to take small profits and when it was
best to hold patiently for big profits?
In previous Bulletins we have discussed the
advantages of using profit objectives expressed
in units of Average True Range. To quickly
summarize that discussion, the ATR expands and
contracts with the volatility of the market. In
a quiet market a profit objective of 2 ATRs
might bring us a profit of $600. In a very
volatile market, two ATRs of profit might be
$1400 or more. By expressing our profit goals in
terms of ATRs instead of fixed dollar amounts we
make them highly adaptive to what is going on in
the market in terms of variations in volatility.
However, what we will propose in this Bulletin
goes a big step beyond that highly recommended
procedure.
We have done a great deal of research using
the Average Directional Index (ADX) that leads
us to believe it is possible to vary our exit
strategy to stay in tune with the trendiness of
the market as well as the volatility. By having
a doubly adaptive profit-taking strategy we can
happily accept small profits when that is the
best the market has to offer or we can change
the strategy and hold out for unusually large
profits when those opportunities are known to be
present.
Volatility as measured by ATR is obviously
important but daily volatility does not always
relate to direction and trendiness. It is quite
possible that we can have lots of big ranges in
a market that is merely going sideways or we
could have small ranges in a market that is
highly directional. It is the correct
combination of directional price movement and
volatility that will allow us to maximize our
profits in relation to what is happening in the
market at any given time. For the best possible
results we want to combine our knowledge of ATR
and ADX.
As we have described in previous Bulletins,
ADX tells us the underlying strength of any
trend. When the trend is strong the ADX will
rise. When the trend is weak the ADX will
decline. This is true in stocks as well as in
futures. It also applies in downtrends as well
as in uptrends. A rising ADX means a
strengthening trend and a declining ADX means a
weakening trend.
Let's go back to our earlier example where
our plan was to take our profits at the 2ATR
level. With this adaptation to volatility we are
counting on the changes in volatility to produce
large profits and small profits based on a
constant target of two ATRs of profit. However
we can go a step further and get even better
results. Under our new plan, when the ADX is
declining we will reduce our expectations and
accept profits of only 1.5 ATRs instead of two.
And when the ADX is rising we will double our
expectations and wait for profits of 4 ATRs
instead of 2. Now we are adapting our exit
strategy to both the current volatility and to
the amount of trendiness in the market we are
trading. As you might expect the difference in
results is dramatic because our profit-taking
strategy is doubly adaptive.
The logic of this strategy should be obvious.
When the market is not trending strongly we
improve our results by reducing our profit
expectations and maintaining our winning
percentage. When the market is trending strongly
we know it is time to abandon our small profit
targets and time to take advantage of some
unusually large profit opportunities.
The examples of 1.5 ATRs as a profit target
in a non-rending market and 4 ATRs as a profit
target in a strong trending market are just
broad guidelines and we need to vary these
parameters depending on the particular market
and type of system we are operating. Short-term
systems may require smaller objectives and
long-term systems may require much larger
objectives.
We suggest you start with a 20 day ATR and a
14 to 18 day ADX. Play around with the units of
profit and see what a dramatic improvement you
can make in your trading results by combining
ADX and ATR.
by Chuck LeBeau |