To be truly complete, a mechanical system must explicitly provide the following information:
- When and how, and possibly at what price, to enter the market
- When and how, and possibly at what price, to exit the market with a loss
- When and how, and possibly at what price, to exit the market with a profit
The entry signals of a mechanical trading system can be as simple as explic in orders to buy or sell at the next day’s open.
The orders might be slightly more elaborate, e.g., to enter tomorrow (or on the next bar) using either a limit or stop. Then again, very complex contingent orders, which are executed during certain periods only if specified conditions are met, may be required for example, orders to buy or sell the market on a stop if the market gaps up or down more than so many points at the open.
A trading system’s exits may also be implemented using any of a range of orders, from the simple to the complex. Exiting a bad trade at a loss is frequently achieved using a money management stop, which tertninates the trade that has gone wrong before the loss becomes seriously damaging.
A money management stop, which is simply a stop order employed to prevent runaway losses, performs one of the functions that must be achieved in some manner by a system’s exit strategy; the function is that of risk control.
Exiting on a profit may be accomplished in any of several different ways, including by the use of profit targets, which are simply limit orders placed in such a way that they end the trade once the market moves a certain amount in the trader’s favor; trailing stops, which are stop orders used to exit with a profit when the market begins to reverse direction; and a wide variety of other orders or combinations of orders.