I was chatting to another trader this morning about exits, and thought it might be time to share my understanding of ‘the basics’ of exit strategy and exit management.
It really is an area of trading that gets very little attention compared to the other end of the trade – the entry. Go into any forex trading forum and you’ll find thread after thread talking about the latest entry method, but very few threads having an intelligent discussion on exits.
It is my belief that your success in trading has more to do with how you exit your trades, than it does with your entry.
Now, in discussing risk management today, we’re not going to consider the use of defined-risk options strategies. I believe they’re a great technique for risk management in a swing trading or position trading timeframe, but that’s perhaps a subject for future articles or videos.
For now, let’s consider standard stop loss placement and exit management.
So, what’s best?
- Should we use a tight stop loss to cut any losses quickly, or a wide stop loss to allow some room to move?
- How quickly should we move the stop loss to breakeven?
- Should we take profits at a target, or should we let the profits run, perhaps trailing a stop behind the price?
Let’s look at some example charts, from the GBP/USD five minute timeframe, although the principles are the same for any market and any timeframe.
In Figure 1 below, let’s assume our setup was the moving average cross, and we entered long at the open of the candle after the first green candle. The entry point is marked at 1.9727. At tight stop might be at the point marked S/L 1, just below the green candle. A wider stop might be at position S/L 2, below the recent swing low, and the 1.9700 level. So, is this a good trade? Well, really our profit and loss depends on how we manage our trade and where we exit.
If we took profit at the 1.9750 level, marked as A, due to expectation of a pause at that round number level, then we had a good trade. If we moved the stop loss to breakeven from either S/L 1 or 2 on the initial rally, and got stopped out at position B, then I guess that’s a good trade as well, although we have no profits to show for our work. If we hadn’t moved our stop loss to breakeven though, we had another opportunity at C for an exit at the 1.9750 level when price stalled there a second time. Once again, a good exit in hindsight. If we didn’t take that though, because maybe we’ve heard that it’s best to always let profits run and to trail stops below the swing lows, then maybe we were stopped out at D for a couple of pips loss, as price broke below the lows of B. This is not a great result at all, but at least the loss is small. It’s certainly better than the larger loss (after having been in profit for quite a while) that occurs when stopped out at point E, as price hits S/L 1, or at point F as price hits S/L 2.
And of course, in this case if you’d acted out of fear and failed to exit at S/L 2, and held onto your trade hoping, wishing and praying for the market to turn around, you’ve been rewarded, as an economic news release turns the market and moves it in your favor to much higher profits. And the market actually went quite a bit higher than this.