The Importance of Exit Strategy – Part 1

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.

 

exit strategy

Figure 1

 

So what was best stop loss technique in this case? Certainly the gambling approach here – no stop loss at all – but there’s no way any serious trader would consider that a valid approach. The market could easily have moved rapidly in the other direction, and possibly will for that trader’s next trade, or the one after, taking them a massive step towards ultimate trading failure. For those of us actually interested in risk management, taking profits at a predefined target (in this case the 1.9750 level at point A) was clearly the best result. Trailing stops just did not work. And a tighter stop loss, in this case S/L 1 was clearly better than a wider stop at S/L 2, in minimizing our loss when the market failed to carry through to higher prices.

Let’s try another example, shown below as Figure 2. It’s the same chart as before. We’ve just moved slightly forward in time.

 

exit strategy

Figure 2

 

This time, we’ve identified the failure to breach the 1.9750 level on two occasions, followed by the establishment of a lower low. We’ll enter short on the break of the lower low, shown in figure 2 at 1.9715. Those employing a tight stop loss might place it at position S/L 1, above the recent green candle and doji. And for those using a wider stop, it might be placed in the vicinity of S/L 2, above the swing highs.

So, what works best here? A wider stop, or a tighter stop? Taking profits at predetermined target levels, or trailing a stop?

In this case, we might have a target of the zeros, 1.9700, which leads to a take profit point marked as A. Good outcome – we’ve banked a profit. If we prefer to see a bit more of a stall at our target levels, rather than just a touch, then we possibly got out at B as the break below the zeros failed. Still a good outcome – the same result as before, around 10 pips.

If we don’t take profits at target points though, but prefer just to trail a stop, then we’ve either got an exit at position C, D or E, depending on whether the stop loss had been moved to breakeven, or remained still at S/L 1 or S/L 2.

And this time, our gambler has not had luck go their way. Holding the trade past the stop loss, or in fact having no stop loss at all, proved to be a terrible strategy, and possibly the last trade that person ever does depending on how long they held on.

So once again, in this example, a tighter stop loss was clearly better than a wide stop in minimizing risk if the trade turned bad, and taking profits at predetermined price levels was clearly superior to trailing a stop.

But is that always the case? No absolutely not. I simply picked two examples that show this outcome.

(By the way – a little side comment here – all those sales ads showing profitable trades as a reason why you should spend your hard earned dollars on their trading strategy – they’ve been selected for that ad simply because they show the outcome you want to see – just like I’ve selected these examples. Don’t believe the charts in the ads, as any indication of potential future profitability. With that public service announcement out of the way, let’s get back to the article…)

Let’s look at a third example.

Figure 3 below shows an entry short on a continuation of momentum downwards, entering short at 1.9672. A tight stop loss may have been placed at S/L 1, just above the long upper shadow. A wider stop may have been placed at S/L 2, above the higher swing high.

 

exit strategy

Figure 3

 

In this case, it’s irrelevant how wide our stop is, as the trade moves quickly in our expected direction. Taking profits though at our predetermined price target, in this case maybe a stall at the 1.9650 level, in the vicinity of point A, is clearly not the most profitable strategy. Trailing a stop beyond the swing highs would keep us in the market much longer, beyond the edge of this diagram, for a total profit of around 100 pips.

Clearly in this case, trailing stops performed better than a predetermined price target.

One more example, in figure 4, below.

 

exit strategy

Figure 4

 

This time, the market has broken down from where price is labeled S/L 2. There is a rally, with two large red candles suggesting a continuation of momentum in the down direction. We enter short following the second large red candle, at 1.9530.

If our strategy was to use a tight stop loss, we might place it in the vicinity of S/L 1, above the recent highs. If our strategy was to use a wider stop, it might be placed above the higher swing high and the start of the downtrend, at S/L 2.

In this case, the tight stop loss takes us out of the market at the upthrust shown by point A. While the wider stop loss at S/L 2 clearly allows us the necessary room to move until the position gets into profit. Taking profits at a predetermined price level, in this case a stall at 1.9500 shown by position B, is again not as profitable as trailing the stop loss lower.

 

So, this time, a wider stop loss is the better strategy on entry. And for ongoing management of the trade we’re better off trailing a stop than exiting at a predetermined profit level.

So what have we learnt from these examples? This is what I’ve observed:

  1. In each case, the profit or loss taken out of the trade was more a result of our chosen stop and exit method, not our entry. For the same entry, there were numerous possible exits, some profitable, some breakeven and some at a loss. This is why I say that, although it’s important to identify a high probability entry, it’s much more important to focus on the exit.
  2. We cannot know, except with hindsight, what will be the most profitable exit strategy for that particular trade. Sometimes a tight stop is best. Sometimes a wider stop is best. And for ongoing management of the trade, sometimes a profit target is best, and sometimes a trailing stop is best.

 

Ok, so the exit is more important than the entry – that’s good.

But there can be no perfect exit strategy that best manages every trade – that’s not good.

So what’s a trader to do?

We’ll follow up later in a continuation of this article, when I discuss the exit principles that I have found work best for me. Till then, no matter where you place your stops, NEVER hold your position as price moves past your stop loss, wishing, hoping and praying for it to come back into profit. That’s gambling – it’s not trading.

Lance Beggs

 

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