Lessons from the Pros

A Discussion About Exit Strategies

Of all the facets of trading, perhaps the most challenging is properly exiting a winning trade. I’ve lost count of how many times I’ve seen first-hand, or have heard of, traders and investors committing the cardinal sin of turning a hugely profitable position into a losing one, simply because they lacked an exit strategy.

In terms of identifying entry points and placing stops in the market, most traders become somewhat proficient – after extended periods of practice. Putting together, and most importantly, executing a proper exit strategy, however, is another story.

Why is it so difficult for traders to either let a winning trade run, or give a nascent trade enough breathing room as to allow it to reach a planned profit objective? Part of the answer has to do with the vagaries of trading live markets. This built-in uncertainty often causes the fragile trader to jettison his position prematurely. The reality is that markets have a tendency to shake out the "weak hands" before embarking on a big move.

The other and probably most prevalent reason why traders have a hard time hanging on to winning trades, is simply because they fixate on their profit and loss rather than what they should focus on – price action. Focusing on how much the trade is making or losing on a per tick basis is one of the biggest impediments to executing a well-planned exit strategy.

Moreover, in the pre-trade analysis stage, we are calm, collected, and have no fear; there’s nothing at stake. However, at that moment when we enter the market, immediately, a lot is on the line. Aside from the money that may be lost if the trade doesn’t work, a bruised ego is now a possibility. The thought of failure, losing, or leaving money on the table also sabotages a well-planned exit. This is food for thought (particularly for those of you that are struggling with your exits).

Because I believe knowing when to take profits is just as important as when to put on a trade, I place a great amount of emphasis on exit strategies when I teach. I stress to students that they have an exit plan BEFORE they put on the trade. In other words, they have to have a methodical approach to manage trades so that they maximize profits and minimize losses.

Notice that we use the term "exit strategy" rather than profit target. This is because this term can have different rules for different types of traders.

For example, a trend follower would stay with a trade using some type of filtering system that would alert him that the trend is changing, thus signaling him to exit the trade. In the chart below, we see an illustration of this method utilizing two exponential moving averages as trend filters. The slower MA (Blue) is used as the line in the sand in terms of holding the trend, and the faster (red) MA, as the exit. We use the faster moving average to exit because in a strong trending environment, price tends to cling to the faster MA and pull away a greater distance from the longer moving average.

The most widely used type of exit is simply having a price target. This can be done by using support, resistance, Fibs, fib extensions, or some combination thereof. The chart below shows a trade done in a simulated account by a student in the last E-Mini Futures class I taught. It’s representative of the method of using an S/R level to enter, as well as using the next S/R level as a profit target. Also important to note is the fact that the price objective was far enough away (8 points) to conform to a favorable risk-to–reward ratio.

Putting on the trade obviously doesn’t ensure that the price target will be attained, so having a systematic way to manage the trade is imperative. Implementing either a mechanical trail stop (which can be found in most trading platforms), or a manual method of trailing a stop once the trade is working is advisable. Defining "a trade that’s working" is where it gets a little tricky, because we don’t want the stop too close. By the same token, we want to capture some profits if the trade falters prior to reaching the expected goal. The degree to which we tighten or loosen the stop is a function of volatility, as well as familiarization of the particular product that one trades.

A general rule of thumb I use is 2-to-1 to break-even. That is to say, if my initial risk is 10-ticks, I will only move the stop to my original entry price if I’m in profit by 20-ticks looking for a minimum 50-tick profit target. This gives enough room in the current market environment to allow a trade to develop.

To some, 20-ticks may be an actual profit target yet, this is where individuality fits in. You have to plan your exits based on a comfort level that is congruent with your style, personality, and needs.

I hope that the next time you’re in a winning trade, you’ll no longer be in the camp of those that do not know what to do and move to the professional level of knowing exactly what to do.

Until next time, I hope everyone has a profitable week.

If you have questions, comments, or you would like a specific topic covered, please email me at gvelazquez@tradingacademy.com.

-Gabe Velazquez