How to get out of a trade (part 1)

Posted on June 27th, 2008 by admin, under online forex trading.

In this series of articles we will discuss the problem of how to get out of a trade once in, i.e., to exit strate­gies, an issue that has
often been neglected in the trading literature.

THE IMPORTANCE OF THE EXIT

In many ways, a good exit is more critical and difficult to achieve than a good entry. The big difference is that while waiting for a good opportunity to enter a trade, there is no market risk. If one opportunity to enter is missed, another will always come along-and a good, active trading model should provide many such opportunities. When a trade is entered, however, exposure to market risk occurs simultaneously. Failing to exit at an appropriate moment can cost dearly and even lead to the dread­ed margin call! We actually know someone who made a quick, small fortune trad­ing, only to lose it all (and then some) because the exit strategy failed to include a good money management stop! To get out of a trade that has gone bad, it is not a good idea to simply wait for the next entry opportunity to come along. Similarly, ening on the side of safety and exiting at the drop of a hat can also drain a trading account, albeit less dramatically through slow attrition. The problem with frequent and hasty exits is that many small losses will occur due to the sacrifice of many potentially profitable trades, and trades that are profitable will be cut short before reaching their full profit potential. A good exit strategy must, above all, strictly con­trol losses, but it must not sacrifice too many potentially profitable trades in the process; i.e., it should allow profitable trades to fully mature.

How important is the exit strategy? If risk can be tightly controlled by quick­ly bailing from losing trades, and done in such a way that most winning trades are not killed or cut short, it is possible to turn a losing system into a profitable one! It has been said that if losses are cut short, profits will come. A solid exit strategy can, make a profitable system even more lucrative, while reducing equity volatili­ty and drawdown. Most importantly, during those inevitable bad periods, a good exit strategy that incorporates solid money management and capital preservation techniques can increase the probability that the trader will still be around for the next potentially profitable trade.

GOALS OF A GOOD EXIT STRATEGY

There are two goals that a good Forex exit strategy attempts to achieve. The first and most important goal is to strictly control losses. The exit strategy must dictate how and when to get out of a trade that has gone wrong so that a significant erosion of trading capital can be prevented. This goal is often referred to as money manage­ment and is frequently implemented using stop-loss orders (money management stops). The second goal of a good exit strategy is to ride a profitable trade to full maturity. The exit strategy should determine not only when to get out with a loss, but also when and where to get out with a profit. It is generally not desirable to exit a trade prematurely, taking only a small profit out of the market. If a trade is

going favourably, it should be ridden as long as possible and for as much profit as reasonably possible. This is especially important if the system does not allow mul­tiple re-entries into persistent trends. “The trend is your friend,” and if a strong trend to can be ridden to maturity, the substantial profits that will result can more than compensate for many small losses. The profit-taking exit is often implement­ed with trailing stops, profit targets, and time- or volatility-triggered market orders. A complete exit strategy makes coordinated use of a variety of exit types to achieve the goals of effective money management and profit taking.

KINDS OF EXITS EMPLOYED IN AN EXIT STRATEGY

There are a wide variety of exit types to choose from when developing Forex strategy of exit. In the standard exit strategy, only three kinds of exits were used in a sim­ple, constant manner. A fixed money management exit
was implemented using a stop order: If the market moved against the trade more than a specified amount the position would be stopped out with a limited loss. A profit target exit was implemented using a limit order: As soon as the market moved a specified amount in favour of the trade, the limit would be hit and an exit would occur with a known profit. The time-based exit was such that, regardless of whether the trade was prof­itable, if it lasted more than a specified number of bars or days, it was closed out with an
at-the-market order.

There are a number of other exit types not used in tbe standard exit strategy: trailing exits, critical threshold exits, volatility exits, and signal exits. A trailing exit, usually implemented with a stop order and, therefore, often called a trail­ing stop, may be employed when the market is moving in favour of the trade. This stop is moved up, or down, along with the market to lock in some of the paper profits in the event that the market changes direction. If the market turns against the trade, the trailing stop is hit and the trade is closed out with a proportion of the profit intact.
A critical threshold exit terminates the trade when the market approaches or crosses a theoretical barrier (e.g., a trendline, a support or resis­tance level, a Fibonacci retracement, or a Gann line), beyond which a change in the interpretation of current market action is required. Critical threshold exits may be implemented using stop or limit orders depending on whether the trade is long or short and whether current prices are above or below the barrier level. If market volatility or risk suddenly increases (e.g., as in the case of a “blow-off top), it may be wise to close out a position on a volatility exit. Finally, a signal exit is simply based on an expected reversal of market direction: If a long posi­tion is closed out because a system now gives a signal to go short, or because an indicator suggests a turning point is imminent, a signal exit has been taken. Many exits based on pattern recognition are signal exits.

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