The Importance of Exit Strategy – Part 3

Welcome back. Based on the information we discussed in parts 1 and 2 of this series; let’s now discuss my personal approach to exit management for short-term intraday trades.

The best way to do this is to first consider, what is my goal from trading, how do my chosen markets move, and what psychological needs do I have to satisfy with regards my trade management and exits.

Firstly, what am I trying to achieve with my daytrading?

My ultimate goal is consistent income. I am not swinging for the big home run trades. If I get one, that’s great, but it’s not the goal.

I trade for income. I accept that not every day will end in profit, but I do aim for each week to end profitably, and certainly every month. So, I can’t wait around for the big moves. I trade the small swings, and I look for consistent income.

So, in developing my exit strategy, we need to consider a requirement for consistent income. This means that both a high percentage of winning trades, and tight risk control, are important factors in the design of my exit strategy. To some degree, traders often see these requirements as mutually exclusive. While a higher percentage of winning trades is often achieved by widening stops, this is not possible in my circumstances, where I need to also keep risk as low as possible. I am satisfied though that the nature of my preferred setups, being at areas of support and resistance, generally ensure a higher probability entry. As such, my stops can be placed as tight as market action allows. In addition, in order to minimize risk, no trade can ever be allowed to place my trading career at risk. The average win/loss ratio must be kept under control such that an average loss is easily overcome by one average win. And any individual loss should never be such that it cannot be overcome by one profitable days trading.

How do my markets move?

I had a reader ask recently whether I believe the saying, ‘the trend is your friend’?

Well, if that saying is true then I believe it is a very fickle friend indeed. I find trend trading very difficult psychologically, due to the lower winning percentage that trend traders typically have to endure as they get chopped up again and again waiting for the big move.

There’s a commonly stated belief that forex markets trend really well. That may be true in longer timeframes, but my experience doesn’t agree with that for the short timeframes that I trade. These markets spend a lot more time in sideways or choppy market action, rather than nicely trending. Of course, when they do trend, it can be a great move.

So, given that is my view of the markets and the timeframes I trade, I need an exit strategy that does not rely on trends developing. Perhaps then, for me, predetermined price targets will be the better strategy.

But what about my psychology? What needs do I have to satisfy, and are they compatible with my goals and my view of the markets?

Firstly, I hate losses, but even more I hate unnecessary losses. So I will immediately take any loss when the system says to exit, in order to ensure the loss is no greater than necessary. Under no circumstances will I accept a lack of discipline on my part leading to a loss greater than the predefined stop loss. So I need a clearly defined exit strategy, and full focus while in a trade to ensure I manage my risk as per my trading plan.

Secondly, there is nothing worse for me than seeing a profitable trade turn into a loss. I’m happy if it retraces and I get out at a small profit. I’m happy if it retraces and I get out at breakeven. But if it’s in profit and retraces, and I let it go to a loss, I’ve failed in my job of managing this trade. So I need to perhaps consider an aggressive movement of the stop to breakeven.

And thirdly, although I would love to catch all large market moves, I’m not too concerned if I don’t trade the whole move. I am happy if I’ve taken consistent small profits out of the trend at each of the high probability entry points.

All three of these psychological requirements are compatible with my goals and view of market direction, as described earlier, pointing to a strategy involving tight risk control, aggressive movement of the stop to breakeven and taking profits at predetermined price targets.

So, having established the general requirements for an exit strategy that meets my goals, my view of the market and my psychological needs, let’s look at it in a little more detail.

 

Initial Stop Loss Management

  1. The initial stops must be tight, but beyond any noise, ideally positioned beyond either the swing high/low or entry candle high/low depending on market action. The stop position must be such that if the price gets to that position then the trade setup and/or timing were incorrect, and I really want to be out of the markets. If the market is not flowing well, and there is considerable candle overlap, consider placing the stops a few pips further to allow for a minor test and breach of the stop area by a pip or two.

  2. The nature of my entries is that, if valid, they should move very quickly in my expected direction. Therefore, in order to minimize the size of my average loss, I can consider an exit of my position before  the fixed stop loss as per the following price action or time based stop rules:

    1. I will exit the trade before the stop loss if price action indicates that my setup may no longer be valid. This includes any significant stalling of price or loss of momentum, or indications of a possible reversal. If price should setup an entry again, I can always reenter, but it’s better to be out of the market waiting for a valid reentry, than just hoping the current one works.

    2. If in doubt at any stage about the validity of my entry signal, I will exit and reassess, rather than wait for price to hit either the stop or target.

    3. After any reasonable period of time without price achieving a profitable position (usually three candles, but flexible depending on price action), I will consider exiting or tightening the stop if price action allows.

    4. Trades against the direction of the trend are treated more aggressively, with respect to early exit.

 

Ongoing Exit Management

  1. Aggressive movement of the stop to breakeven as soon as price shows a loss of momentum. If price was only slightly into profitability, consider tightening the stop loss towards breakeven if price action allows. Both these actions may result in getting stopped out on a retracement, before price moves in the expected direction. That’s fine. I accept that. Having exited, I can objectively reassess the entry setup, and if applicable reenter the market. And if I don’t get a reentry, and the price moves on without me, I don’t mind. I missed this one, but getting out was the right thing to do. The retracement could easily have continued in the opposite direction, stopping me out for a greater loss. I have minimized my risk. I have traded well.

  2. Trades against the direction of the trend are treated more aggressively, with respect to early movement of the stop to breakeven.

 

Multiple Parts

  1. Having established requirements for consistent income, my primary exit strategy will be through a predetermined price target. However by trading multiple parts to each trade, I will provide myself greater flexibility

  2. Part one will always operate with a take profit level. The location of the target is flexible, depending on my assessment of price action, but will typically be the next area of minor or major support or resistance.

  3. Part two will involve either of the following:

    1. In a smoothly trending market, this part will be managed via a trailing stop, positioned beyond swing highs/lows. It may be moved tighter for any parabolic or impulse moves, to lock in a portion of those extra profits – consider positioning the stop based on smaller timeframe price action.

    2. In a sideways market, or a choppy market (whether trending or not), part two will be exited via a target level, typically the next major support or resistance level. Supposedly the market is not trending around 70% of the time. Therefore this is the default exit method. Trailing stops should only be used when the markets is visibly trending in a very smooth fashion.

  4. If price stalls prior to achieving either target, part one may be exited anytime. Part two should be should be given more opportunity to reach its target, or a breakeven exit, however may also be exited if I feel the trade has lost its edge.

 

News or Economic Releases

  1. Prior to any news or economic release in which it is reasonable to expect volatility, consider either closing out trades, or if well in profit then just tightening the stops right up. If extreme volatility is possible (for example during the monthly Non-Farm Payroll release, or any interest rate decision), then part two profit targets may be removed from the market.

 

That’s essentially it. It’s quite simple, but has considerable flexibility to allow for discretionary changes based on my feel of the market flow.

I’ll repeat a few of the disclaimers already mentioned in other articles. This exit strategy is simply the one I have found most effective for me. It is not necessarily the most profitable. In fact my testing shows slightly better results by just trading part two positions, however it’s optimized to suit my psychology which needs these regular profits, no matter how small. I like it, it works for me. There’s no guarantee it will suit your style of trading, or in fact will even be profitable for you at all. By all means, take the parts you like and test to see if they fit with your strategy. The key word though is ‘test’. Test everything before taking it live.

There are numerous variations on this multiple part approach as well, so adapt that approach as you see fit. And don’t just limit your testing to the multiple part exit. Why not also try scaling in, with each part at different prices?

I hope you got value out of that. I’d like to finish up with acknowledging four great traders who have been influential in helping shape my beliefs about trade management and exits, through sharing a couple of exit based quotes from their books or websites:

 

Larry Williams in “Long Term Secrets to Short Term Trading”:

  • “Based on my research and experience, I have developed a powerful and profitable belief system: I believe the current trade I am in will be a loser… a big loser at that.”
  • “Every major loss I have had trading (and I’ve had more than my fair share) has come from believing my current trade would be a big winner, so I did not follow the rules of the game. Adopt my belief system, that this trade will most likely be a loser, and you sure as heck will protect yourself!”

 

 Mike Reed, from the great articles on his website, and from his book “Read the Greed”:

  • “Your concern is ‘limiting losses’. I care more about this than anything else in trading.”
  • “Every successful trader I’ve met has a way of getting out early on bad trades.”
  • “No matter which route you take, identifying and exiting losers is the key to trading.”
  • “Never let a gain turn into a loss. This will mean getting out of most trades a little (or a lot) too soon. You just have to live with it. Swing for home runs (greed) will ruin your trading. There is no mechanical formula that I know of, (such as, “move your stop to break even after you get 3 ticks gain”) that will work. You have to develop a feel for how the market is acting at the moment, and use your feel to reduce your target or advance your hard stop. This comes with experience.”
  • “Simply put, when the edge is gone, get out!”
  • “Once I enter a trade, I do so because I have an edge, and the clock begins to tick. The trade should begin to go my way very soon. I cannot assume that I’m right and let the market move against me and continue to move against me just because I want to be right. Instead, the market must quickly prove that my entry was correct, and move in my direction, or I assume that I am incorrect, and exit the position. You must assume you are incorrect, and exit the position. You must assume you are incorrect until you are proven correct.

 

Larry Conners and Linda Rashcke, from “Street Smarts”:

  • “The main goal of each trade is to minimize risk rather than maximize profit.”
  • “Remember that both in short-term trading and mechanical systems, the distribution of winners is skewed. Most of a month’s profits might come from only two or three big trades. Much of the time the individual profits may seem small, but more importantly the losses should be small, too.”
  • “If you keep your losses to a minimum on every trade, you will have 80 percent of the battle won.”
  • “Be pleasantly surprised when a windfall occurs, but never be looking for “the big one”. The market will decide how much profit to give you. Only you can decide how much to limit your loss.”
  • “The real skill is in not losing money.”
  • “Maybe there is no such thing as the perfect exit strategy, but you have to lock in profits when they’re there, even if it means getting stopped out of a small reaction. People tend to focus on the one out of 20 times they really did leave money on the table and not look at all the other trades where getting out was the right thing to do.”

 

Lance Beggs

 


Written by

YourTradingCoach – Admin

2 Comments to “The Importance of Exit Strategy – Part 3”

  1. Antonio says:

    Thank you, as you said in the first part, it is very difficult to find exit strategies in forums. I started today looking for Money Management strategies and luckily I have found this, which is in fact, a Money Management strategy. If I had started focusing in maximizing wins rather than in minimizing losses as you explain here, surely I would be the next noob leaving forex. Hope I can persist.

    John D. Rockefeller said something in a similar vein—“Take care of the dimes and the dollars will take care of themselves”

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