Exit trading strategies: When to exit your trade
Financial markets don’t move in one direction forever – they move up and down on significant news and events. Traders who let their profits run can ultimately incur significant losses; to prevent them, it’s vital to exit trades at the right time for your strategy.
By establishing and applying well-designed exit trading strategies, you can not only lock in gains and cap losses, but also remove any emotional influence from your decision-making process. Exit strategy definition refers to a plan you have thought out in advance on when to exit a trade.
For example, a loss-averse trader thinking that the price will drop could miss a better exit opportunity. Here we take a look at the exit strategies in contracts for difference (CFD) trading and how they can help you make timely decisions without emotional biases.
CFDs are financial derivatives that use margin and leverage. This means both your losses and profits can be magnified. Make sure to conduct your own due diligence before trading, and never trade money you cannot afford to lose.
Stop-loss and take-profit in CFD trading
Exit trading strategies set out reasons for leaving a CFD trade. They can involve placing stop-loss and take-profit orders.
Stop-loss orders are used to specify the exact price at which to close a losing CFD position. A stop is an instruction for your broker to buy or sell when an asset’s price reaches the point 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.
Note that a stop loss does not guarantee exit at a set price in extreme market conditions, for example, when the market crashes rapidly. A guaranteed stop loss, on the other hand, ensures that your position is closed at a preselected price, yet comes at a higher fee.
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 CFD ABC and place a $2 trailing stop. As the stock CFD 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 stops associated with long positions can only move up and never down. For short positions, it only trails down and never up.
A take-profit order is used to specify the exact CFD 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 when trading CFDs. Consider the asset’s volatility: the price should have enough room for fluctuations. If you place orders too narrowly, they can be triggered 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 CFD trading strategy, be it day trading exit strategy, swing trading or any other.
Risk reward
When it comes to exit strategies for stock CFDs, or any other asset-linked CFDs, another important factor to keep in mind is the risk-reward ratio (RRR). This shows how much you are ready to lose in comparison with the profit you hope to earn on a trade.
For example, you go long on one stock CFD 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 CFD price could 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 potential 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’s commonly believed that the most preferable correlations are 1:2 or 1:3. The ratio 1:1 is seen as too risky.
Risk tolerance
Risk tolerance refers to your ability to handle a loss. If you take on too much risk, there’s a danger you may panic and sell at an inappropriate time.
A CFD trader has to pick a comfortable percentage of capital they are ready to lose on a single position. 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.
For example, 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.
Above is 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.
Exit trading strategies
There are numerous CFD stock trading exit strategies to choose from, most of them based on technical indicators. You can also use these strategies with other asset-linked CFDs such as commodities and FX. Below are the popular exit strategies CFD traders can use to set up their stop-loss and take-profit orders.
ATR
The average true range (ATR) indicator can be used as a CFD stock exit strategy to determine signals to end 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, 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.
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 levels 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 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 traders often use these price points to place stop-loss orders. 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 so that traders aren’t thrown out of the position prematurely.
Support and resistance can also be used to exit using take-profit order. They are prominent price areas that can serve as targets to exit. This has to be done with the appropriate risk/reward in mind.
Entry criteria disappears
This exit strategy suggests that you should get out of a profitable trade once the reason for an entry has disappeared.
Let’s imagine that stock CFD X makes a series of higher swing highs and higher swing lows. This indicates an uptrend, so you decide to buy. In a while, the price of asset X demonstrates a lower swing high and lower swing low. The reason for you having entered this position is gone, and according to this CFD stock exit strategy, you should leave the trade.
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 us that the reason to enter has vanished.
Final thoughts
Note that the exit trading strategies above should not be used as a substitute for your own research. Markets are volatile, and you should always conduct your own due diligence before any trading decisions.
Make sure to look into the latest news, analyst commentary, technical and fundamental analysis, and have a risk-management plan in place. Remember that past performance does not guarantee future returns, and never trade money you cannot afford to lose.
FAQs
What is an exit strategy used for?
An exit strategy defines the price level at which a trader should exit a trade. Exit strategies could minimise the impact of emotional biases such as loss-aversion in decision-making.
What is a good exit indicator?
Some popular exit indicators include support and resistance levels and average true range (ATR).
What does exit mean in trading?
Exit in trading means closing an open position. For example, in a long trade it means selling the asset, while in a short position it means buying and returning the borrowed asset.
