The Basics Of Exit Strategies

When trading in forex (as with trading in any asset), market participants will want to follow the age-old recommendation to "buy low and sell high." To do this, they will clearly need to develop a rationale and trading strategies designed to enter the market when asset prices are low.

But what about the other end of the trade? When is it an appropriate time to get out? Many market participants and experts note that traders frequently neglect to set up a strategy for exiting trades and can end up unnecessarily missing opportunities to take profits. For many people, this problem leads to losses stemming from untimely market moves.

In non-directional trading, traders can work within a pre-established time or price range with offsetting trade entrance and exit points. However, developing exit strategies can be more critical in directional trading, where traders seek to gain money on trends in price movements. In this instance, timing market exit is vital to success. If traders wait too long to close the position, a pullback can severely cut into profits!

Limit And Stop Loss Orders

Exit strategies typically involve establishing a rationale for exiting a trade. Although such strategies vary, setting prior stop-loss and limit prices are typically used to make the exit:

Stop-loss Order

A stop-loss order is a protective order that closes out a trade when the trade has gone against you a predetermined amount. Stop losses are ideal for beginners and seasoned market veterans alike. They ensure that each trade has a finite liability, no matter how price moves. For long positions, a stop-loss order is placed beneath the trade's entry price; for shorts, stops are placed above entry price.

Limit Order

A limit order is placed to close out a profitable trade at a predetermined price before market conditions become unfavourable. When it is used to exit a positive trade, a limit order is referred to as a "take profit" or "profit target." For long strategies, a limit order is placed above the trade's entry market price; for shorts, limits are placed beneath entry.

These orders contrast to market orders, in which the trader is required to accept a price that is being offered in the market at the moment of a trade. Market orders are executed at the best available price and filled instantly at market. Both stop-loss and limit orders rest at market for an undetermined amount of time before being executed.

Why Worry About An Exit?

Currency prices can change direction unannounced and unexpectedly on news events or movements of significant volumes of capital within markets. As a result, traders who may have been expecting a currency to move through a given price range can get caught out and lose planned profits on a trade.

To avoid this situation, forex trading specialists recommend that traders establish exit strategies that can anticipate the ends of trends, or limit losses, in case of unexpected reversals. Given extreme market volatility, it's important that traders know where to exit the market ahead of time.

Avoid An Emotional Response

Another reason to establish an exit strategy is to avoid an emotional response to trading that will induce errors. For example, a trader can become overconfident that a trend will continue and decide to let profits run. In this case, the trader chooses to pass up an ideal target price in the hopes of making big profits. On the other hand, when a trader is unnecessarily nervous about the sustainability of a trend, premature exits can limit the opportunity for gains.

Establish A Profit Target Price

A powerful way to ensure that neither of these issues plagues performance is to establish a profit target price before taking each trade. By doing so, it is possible to quantify gains and losses over the long-run.

Setting Up An Exit Strategy: Factors To Consider

Before setting up a trading exit strategy, traders are advised to consider a few basic factors to determine which type of strategy they will use and how they will employ it.

Trend Confidence

The first of these factors is where they have chosen to enter the trend and how confident they are that it can continue. A trader who enters a highly volatile market, with wide price swings, will likely consider a different approach than a trader who enters a market that appears to be on a long, and less-eventful trajectory with little price volatility.

Risk Tolerance

Another important factor for a trader to consider is risk tolerance. To quantify this, experienced traders frequently work with "risk-reward ratios," which describe how much risk, or loss, a trader is willing to accept in comparison with the amount of gain they are hoping to achieve. Such ratios can be the cornerstone of any trading plan's risk management parameters.

A wide variety of risk-reward ratios may be implemented to capitalise on an asset's price action. Risk-reward ratios might be set at levels such as 1:1.5, 1:2, 1:4 or more, depending on how much risk a trader deems acceptable.

Before establishing a risk-tolerance level, traders may want to consider how much they have available in assets to trade with, as well as their strategy, to custom fit their money management. Money and risk management aren't one-size-fits-all exercises! Each is unique according to the individual trader's situation.

For instance, day trading requires a different money management approach than swing trading. This is because day traders engage the market on shorter time frames than swing traders do. Accordingly, the risks are smaller as the exposure to market volatility is reduced.

Common Exit Strategy Approaches

The following are two of the most common approaches to an exit strategy.

Exiting on Weakness

This strategy is more common for longer-term trades, and it involves the straightforward approach of seeking to anticipate a weakness or a correction in a trend to establish an exit point.

With this approach, however, the trader risks seeing the trend resume and may be subject to the frustration of forfeiting potential further profits. Some of the technical analysis indicators used to identify trend weaknesses for exits can include moving averages, Ichimoku Cloud analysis, analysis of prior swing lows and analysis of double tops or bottoms.

Exiting On Strength

This is a strategy that is more favourable for short-term, breakout trades. In this approach, a trader will look for a signal of strength in the direction of the initial entry to the trade in order to make an exit.

The rationale behind this approach is that you will be exiting the trade to lock in certain profits before the rest of the market jumps in on the trend and possibly prompts a later reversal. However, the latent risk to this approach is that you could be abandoning your position just as a longer term trend is beginning. Some of the indicators traders use to identify trend strength exit points include pivot targets, percentage ATR exits and oscillator extremes.

Stop/Limit Using Support And Resistance

With this approach, the trader will set a stop and limit near resistance and support levels in such a way that they have a positive risk to reward ratio. To begin, the trader will seek a swing in charts to a higher level and set a stop loss at several pips higher than that level. At this point, the trader can use a risk-reward ratio to set a limit.

If the stop loss is 50 pips below the entry point and the trader's preferred risk-reward ratio is 1:3, then a limit can be set at 150 pips above the entry point. For every £1 put at risk for loss in this trade, the trader could gain £3.

Trailing Stops Based On Moving Averages

With this approach, the trader will continue to set new stop losses on a revised basis throughout the duration of the trade depending on where the price is in relation to a moving average. The principle behind this strategy is that if the price crosses a moving average line from one side to the other, then it is a signal that the price trend is shifting and the trader will want to close the position.

If during an uptrend, for example, the trader sets a stop loss at a 100-period exponential moving average that is 60 pips below a trade entry point, and they have adopted a risk-reward ratio of 1:2, they will want to set an initial limit at twice the risk, or 120 pips, above that point. These exit points can then be updated on a periodic basis to assure that the trader is taking maximum advantage of a trend. Additionally, these parameters may also be used to adjust position size in the live market.

One impractical aspect of this approach is that the trader will be required to monitor shifting prices to alter stop losses, for example, each time a new candle is formed on an interactive trading chart. This problem may be remedied by the use of automated software that is available for some trading platforms.

Volatility-Based Strategy

This strategy takes into account the average size of price swings in the market in any given time frame to set stop losses and limits. To employ this approach, a trader can use a volatility indicator, such as the average true range indicator (or ATR). The philosophy is that pre-set exit points will be determined according to the full range of prices that have actually been practiced in the market during a given period.

To establish these exit points, the trader can set a stop-loss at 100% of the ATR. If this range is equal to 35 pips, and the trader has a preferred risk-reward ratio of 1:2, then he will want to set his limit at 70 pips above the entry point. One advantage of using the ATR indicator is that once exit points are established, they won't require new updates for the duration of the trade.

Summary

There are several approaches available for establishing exit strategies that can help limit the amount of risk traders assume while increasing the odds for making profits even when conditions in the market appear adverse and unpredictable. Data has shown that traders tend to forfeit more gains when they fail to employ deliberate strategies for exiting trades.

As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in exit strategies or other approaches to trading. Losses can exceed deposited funds.