Why have an exit strategy in trading?
Financial markets don’t move in one direction forever – they move up and down based upon significant news and events. Traders who just let their profits run can ultimately incur significant losses. To prevent them, it’s vital to exit trades at the right time.
By establishing and applying well-designed exit strategies, you can not only lock in profits and cap losses, but also remove any emotional influence from your decision-making process.
For example, a loss-averse trader may miss an exit opportunity during losses, thinking that the price will change the direction. Or vice versa, they may fear the reversal and get out of a profitable trade prematurely. A strategy, if you keep to it, will help you leave the trade emotionlessly and timely.
Stop-loss and take-profit
Exit strategies in trading set out reasons for leaving a trade and involve placing stop-loss and take-profit orders to exit.
Stop-loss orders are used to specify the exact price at which to close a losing position. A stop is an instruction for your broker to buy or sell an asset when the asset price reaches the point of loss you’ve indicated. When the stop-loss is triggered, it automatically turns into a market order, helping to minimise losses if the price moves against you quickly.
Take-profit is used to specify the exact price at which to close a profitable position. Like a stop-loss, a take-profit converts into a market order when triggered.
There should be rationale behind placing a stop-loss or take-profit order. Consider the asset’s volatility: the price should have enough room for fluctuations. If you place orders too narrowly, they can be triggered too early.
There are multiple methods that take price volatility into account: technical or fundamental factors, support and resistance, the Fibonacci levels, indicators and patterns, and more. However, they should be put into practice based on the time frame associated with your trading strategy – day trading, swing or position trading, etc.
In addition, there is a more flexible variation of a stop-loss order: a trailing stop. Trailing stops allow the position to remain open providing the price is moving in the right direction. In fact, it’s possible to set a trailing stop/stop-loss in combination with take-profit orders for better trading performance.
Sometimes traders also use a partial close: it locks in profit and leaves a fraction of a position open to take advantage of the next price target.
Multiple take-profit levels
1. The Triple scale method is about having three take-profit levels and splitting your position size into three.
After one third is reached, you have to lock in one third of your position size. If the price keeps moving in your favour and two thirds of take-profit are reached, you lock in one third of your position size again and move your stop-loss to break-even, or in other words, to the open price level. From this moment on, your trade becomes risk-free. After three thirds, the whole take-profit is filled.
2. The 80/20 method also implies that you have multiple take-profit targets. Once the first one is hit, you lock in 80% of the trading position. The remaining 20% are left open to target the next take-profit level.
3. Take-profit halfway
Using this exit strategy method, you have to lock in half of your trading position when the price has crossed a halfway point in your direction. Once the first take-profit level has been reached, it’s recommendable to move your stop-loss order to break-even.
A trailing stop is placed at a predetermined percentage or price currency value away from the asset’s market price. As the price moves, the trailing stop automatically moves with it, but when the price stagnates, the stop-loss price remains at its most recent level. This type of order is designed to cap losses by leaving a trade and collect profit as long as the price moves in a favourable direction.
For example, you open a long position on stock ABC and place a $2 trailing stop. As the stock price consolidates, the trailing stop also moves up until the price stalls, at which point it will remain at its most recent level. However, trailing stop associated with long positions can only move up and never down. For short positions, it only trails down and never up.
When it comes to exit strategies, another important factor to keep in mind is risk-reward ratio (RRR). This shows how much you are ready to lose in comparison with the profit you expect to earn on a trade.
For example, you go long on one stock priced at €50.40 and set a stop-loss at €50.20. Thus, the risk per trade is €50.40 – €50.20 = €0.20. According to your estimates, the stock price will rise to reach €50.80, so you choose this point to be your reward target. The potential profit is €50.80 – €50.40 = €0.40. Now that we have both the risk and reward, we can calculate the risk to reward ratio per trade: €0.20 / €0.40 = 0.50 (or 1:2).
RRR can be 1:1.5, 1:3, 1:4 or more, but it is commonly believed that the most preferable correlations are 1:2 or 1:3. The ratio 1:1 is too risky.
Risk tolerance is your ability to handle a loss. If you take on too much risk, there’s a danger you might panic and sell at the wrong time.
A stop monitors your position – and alleviates some of your risk – so you don’t have to. That way you can relax knowing you are protected against downside risk. Furthermore a stop-loss can be adjusted when the price of a stock goes up, locking in profits. This gives you piece of mind that your winner will never become a loser.
A trader has to pick a perfectly comfortable percentage of capital he or she is ready to lose on a single trade. The more risk tolerant a trader is, the more loss they are ready to withstand. The most recommendable and common risk-per trade level is 2% of your capital.
An example of a stop-loss, trailing stop and partial take-profit order combined, where the stop-loss is set at a loss of 2% of capital. The trailing stop is activated after break-even (entry price). Setting the take-profit order at 6% of capital makes a risk-reward ratio of 1:3. The closure is divided into three parts: the first part is ⅓ of the take-profit, and the second is ⅔.
The average true range (ATR) indicator can be used to determine signals to exit a trade. ATR is a common indicator that helps estimate the asset’s average volatility, taking into account a certain time frame (minute, hour, day, or week) for an indicated period.
To calculate the stop-loss level based on ATR, you have to multiply the current ATR by 0.5, 1, 2, 3, etc. The multiplier depends on a trading strategy you stick to: generally, the longer-term investors multiply ATR by 3, while short-term traders commonly use 2 as a multiplier. The value you receive upon the multiplication is a stop-loss level. (Find more on ATR-based stop-losses here).
Traders can use the average true range to generate exit signals. The logic behind the strategy is to subtract the ATR value from the recent close. A significant change in the market has happened whenever it closes more than one ATR under the recent close price.
Support and resistance
Support and resistance are key levels that can be used to establish your price targets – the points at which you are willing to open or exit a trade.
Support is the lower limit line – the floor – which gathers a large number of traders willing to buy, causing an asset to bounce back up. Resistance is quite the same, but on the upper side: it gathers sellers when the trend line goes up, which makes the asset price move down in the opposite direction.
Trends sometimes reverse at these levels. That’s why we can use these price points to place stop-loss orders (more on this approach here). The general recommendation is to set stop-loss orders slightly below support and slightly above resistance. This will give the price some room to fluctuate, and you won’t be thrown out of the position prematurely.
Support and resistance can also be used to exit using take-profit. They are prominent price areas that can serve as targets to exit. When you enter a trade, you have to establish price targets at which you’re willing to leave. This has to be done with the appropriate risk/reward in mind. If you risk $100 on a trade, but will earn $300 if the price hits your target, your risk/reward is 1:3.
Overall, by setting stop-loss and take-profit orders, you may stop monitoring your positions – eventually, either stop-loss or take-profit will be triggered.
Exiting on a trend weakness
This exit strategy is suitable for longer-term traders. It implies that you look for a trend weakness to establish an exit point. To identify such a point, traders use moving averages, double top or bottom chart patterns, prior swing lows or the Ichimoku cloud indicator.
Exiting on the trend weakness has a clear disadvantage. A trader risks leaving a trade on a weak low before the trend bounces back. Emotionally, this can be hard to admit that you’ve taken your money out on a correction. Frustration at losing the potential profit is followed by beating yourself up.
Entry criteria disappears
This exit strategy suggests that you should get out of a winning trade once the reason for an entry has disappeared.
Let’s imagine that asset X make a series of higher swing highs and higher swing lows. This indicates an uptrend, so you decide to go long. In a while, the price of asset X demonstrates a lower swing high and lower swing low. The reason why you’ve entered this position is gone, so you should take an exit.
Here’s another example. You may enter a long trade following a bullish indicator. When the indicator no longer confirms your long position, you give it up and leave the trade.
The drawback of this trading exit strategy is its subjective nature. The reversal of a trend or the change of an indicator don’t necessarily mean that it’s the best time to leave. Such things tell that the reason to enter has vanished.